Monday, December 20, 2010
Monday, December 13, 2010
Ramblings of a Portfolio Manager
Does Chinese Inflation Matter?
For over a year now we have been hearing in the press that the Chinese economy is in a bubble—that too much stimulus in the form of post-crisis Government-injected liquidity has generated scores of worthless, non-productive infrastructure projects, related speculation on real estate and a resulting runaway inflationary economy. The paradox is that many of those bright economists and money managers repeating this mantra also couch their warnings in “if you can believe the data.”
Are the Chinese, in fact, lying about growth and inflation (i.e. is it really lower than reported figures) or do they really have the makings of an overheated economy. And if their economy is overheating, should the People’s Bank of China be concerned along with, by proxy, the rest of the world? Let’s address the purported lack of candor for a second. The story goes that, though China reports an unemployment rate of just 4%, they are really only counting permanent labor in the big cities, and only short-term contracts in rural areas, and there is a big mismatch between skills needed and those available. Unemployment levels, therefore, are understated. As for GDP, the pundits’ favorite theory is that the Country’s growth is supported only by the sheer volume of money injected by the Central Bank and that it is all being funneled into worthless projects, which will contribute no productivity or return to GDP once completed—i.e. once the gas pedal is released, the car will stop —a Chinese Potemkin Village, to mix metaphors. Along with this axiom comes the assertion that the Chinese are just making up the GDP growth figures—that they are doing so not so much for the world’s benefit but to preserve domestic content. On this score there may be some theoretical basis (although not reality) for such allegations. Many economists believe China needs to sustain nearly an 8% GDP growth to keep full employment in the cities or risk many of the rural peasants who migrated there in search of a better life losing their jobs, thereby promoting internal strife. However, just releasing big numbers does not keep people in jobs. We have yet to see a reverse migration of workers back to the countryside nor have we seen any domestic unrest resulting from economic conditions (and believe us, even the Chinese State couldn’t hide that from the world). Doesn’t sound like overstated employment figures to us. As for the productivity of projects completed or in the works, there may be some truth behind the claims, yet the projects often cited (unoccupied apartment buildings, empty towns) are not necessarily ones that will be worthless in the future (unlike our own bridges to nowhere). They are more like bets on future growth and if the State really can engineer a soft landing to 8-9% annual growth, these projects will doubtless become productive and bear economic fruit in the near future. Finally, as of Friday, the Central Bank lifted bank reserve requirements by 50 basis points, the sixth such hike this year. And that is no lie. Central banks don’t just hike reserve requirements to bolster their own government’s “lies” about economic growth—not even in a well-controlled state like China. So there must be some truth the to GDP numbers we have been seeing.
But if the Chinese aren’t lying about their growth, employment and inflation figures, is there cause for concern? Over the weekend the Central Bank released their inflation data for November. Expectations were for 4.7% although the whisper number was for over 5%. The data came in at 5.1%. After Friday’s hike, the Chinese so-called benchmark interest rate stood at 5.56%. That would leave real interest rates at or near zero—what we are trying to engineer in the US and ordinarily a cause for inflationary concern in an economy already back up on its feet. But are rates really hovering at zero in China? No. A further look at Saturday’s inflation data casts a slightly different picture on the so called “overheated” nature of the Chinese economy. Ex-food, the actual inflation rate was only 1.9%--not far above that of our own lackluster economy. That means fully 63% or more (some peg it as high as 78%) of stated Chinese inflation comes solely from rising food prices, which have jumped 12% this year alone but are expected to moderate over the next twelve months. In the US inflation data is typically presented “ex food and energy” as these inputs tend to be volatile and are not considered “structural” components of a long-term inflation picture—certainly the Federal Reserve wouldn’t consider a domestic rate hike based on inflation data, over half of which was based on these non-structural inputs. Why should it be any different in China? In fact, China managed to produce year-over-year industrial output growth of 13.3%, a true indicator of economic health, with retail sales up 18.7%--important to the government’s effort to boost domestic consumption—all with a “core” rate just slightly higher than ours. Not bad in our opinion. In more fully developed economies, like the US, where there is much less “slack” in capacity utilization, employment or wages, such growth would already be producing significant inflation. In an emerging economy like China’s, where there is such slack, high growth can still occur with modest inflation. This is what we are seeing now.
So, back to the question, what will the Chinese do with their benchmark rate and should we be concerned? Reviewing the components of Chinese inflation, if taming the “stated” inflation rate is the policy goal, raising rates will do little to make a dent. People don’t buy food based on interest rates either here or in China—which is why our Fed tends to factor out that part of our inflation data when considering its next move. And, perhaps, that is why we have seen the PBC wait so long to hike the benchmark rate even in the face of very high stated rates of inflation. However, the Chinese Central Bank has a deeper objective in its rate policy and that is reigning in real estate speculation. There, as it does here, rates do matter and the hope is that the Central Bank wont kill the golden goose while aiming at an entirely different target. Will it do so? As the theory goes, if a bunch of educated PhDs here in the states have difficulty engineering a soft landing in an economy whose metrics are well understood, how can a bunch of ex-communists accomplish that in a wild west version? Well, let’s not forget that for better or worse, most of the economists and analysts manning the PBC were educated in the West—in the finest graduate schools, no less. So what we can expect to see in Chinese economic policy probably wont be much different from what a western Keynesian or monetarist would espouse. That’s not to say they will get it right (as certainly economists here seldom do) but let’s not assume they will just be shooting from the hip either. There are lots of tools to accomplish their objective, short of raising interest rates (as we have seen with the reserve rate hike, for example). In our opinion, there most likely will be rate hikes to come in China but they will be modest, measured and well telegraphed. And the PBC will put forward other programs to slow real estate speculation, as they already have. That’s a page from our own Federal Reserve’s manual, something the Chinese have long studied. And if we are right and food inflation moderates, perhaps the cycle of tightening might be much shorter than most forecasters expect. That would be good news for the world economy and, of course, the world’s equity markets.
For over a year now we have been hearing in the press that the Chinese economy is in a bubble—that too much stimulus in the form of post-crisis Government-injected liquidity has generated scores of worthless, non-productive infrastructure projects, related speculation on real estate and a resulting runaway inflationary economy. The paradox is that many of those bright economists and money managers repeating this mantra also couch their warnings in “if you can believe the data.”
Are the Chinese, in fact, lying about growth and inflation (i.e. is it really lower than reported figures) or do they really have the makings of an overheated economy. And if their economy is overheating, should the People’s Bank of China be concerned along with, by proxy, the rest of the world? Let’s address the purported lack of candor for a second. The story goes that, though China reports an unemployment rate of just 4%, they are really only counting permanent labor in the big cities, and only short-term contracts in rural areas, and there is a big mismatch between skills needed and those available. Unemployment levels, therefore, are understated. As for GDP, the pundits’ favorite theory is that the Country’s growth is supported only by the sheer volume of money injected by the Central Bank and that it is all being funneled into worthless projects, which will contribute no productivity or return to GDP once completed—i.e. once the gas pedal is released, the car will stop —a Chinese Potemkin Village, to mix metaphors. Along with this axiom comes the assertion that the Chinese are just making up the GDP growth figures—that they are doing so not so much for the world’s benefit but to preserve domestic content. On this score there may be some theoretical basis (although not reality) for such allegations. Many economists believe China needs to sustain nearly an 8% GDP growth to keep full employment in the cities or risk many of the rural peasants who migrated there in search of a better life losing their jobs, thereby promoting internal strife. However, just releasing big numbers does not keep people in jobs. We have yet to see a reverse migration of workers back to the countryside nor have we seen any domestic unrest resulting from economic conditions (and believe us, even the Chinese State couldn’t hide that from the world). Doesn’t sound like overstated employment figures to us. As for the productivity of projects completed or in the works, there may be some truth behind the claims, yet the projects often cited (unoccupied apartment buildings, empty towns) are not necessarily ones that will be worthless in the future (unlike our own bridges to nowhere). They are more like bets on future growth and if the State really can engineer a soft landing to 8-9% annual growth, these projects will doubtless become productive and bear economic fruit in the near future. Finally, as of Friday, the Central Bank lifted bank reserve requirements by 50 basis points, the sixth such hike this year. And that is no lie. Central banks don’t just hike reserve requirements to bolster their own government’s “lies” about economic growth—not even in a well-controlled state like China. So there must be some truth the to GDP numbers we have been seeing.
But if the Chinese aren’t lying about their growth, employment and inflation figures, is there cause for concern? Over the weekend the Central Bank released their inflation data for November. Expectations were for 4.7% although the whisper number was for over 5%. The data came in at 5.1%. After Friday’s hike, the Chinese so-called benchmark interest rate stood at 5.56%. That would leave real interest rates at or near zero—what we are trying to engineer in the US and ordinarily a cause for inflationary concern in an economy already back up on its feet. But are rates really hovering at zero in China? No. A further look at Saturday’s inflation data casts a slightly different picture on the so called “overheated” nature of the Chinese economy. Ex-food, the actual inflation rate was only 1.9%--not far above that of our own lackluster economy. That means fully 63% or more (some peg it as high as 78%) of stated Chinese inflation comes solely from rising food prices, which have jumped 12% this year alone but are expected to moderate over the next twelve months. In the US inflation data is typically presented “ex food and energy” as these inputs tend to be volatile and are not considered “structural” components of a long-term inflation picture—certainly the Federal Reserve wouldn’t consider a domestic rate hike based on inflation data, over half of which was based on these non-structural inputs. Why should it be any different in China? In fact, China managed to produce year-over-year industrial output growth of 13.3%, a true indicator of economic health, with retail sales up 18.7%--important to the government’s effort to boost domestic consumption—all with a “core” rate just slightly higher than ours. Not bad in our opinion. In more fully developed economies, like the US, where there is much less “slack” in capacity utilization, employment or wages, such growth would already be producing significant inflation. In an emerging economy like China’s, where there is such slack, high growth can still occur with modest inflation. This is what we are seeing now.
So, back to the question, what will the Chinese do with their benchmark rate and should we be concerned? Reviewing the components of Chinese inflation, if taming the “stated” inflation rate is the policy goal, raising rates will do little to make a dent. People don’t buy food based on interest rates either here or in China—which is why our Fed tends to factor out that part of our inflation data when considering its next move. And, perhaps, that is why we have seen the PBC wait so long to hike the benchmark rate even in the face of very high stated rates of inflation. However, the Chinese Central Bank has a deeper objective in its rate policy and that is reigning in real estate speculation. There, as it does here, rates do matter and the hope is that the Central Bank wont kill the golden goose while aiming at an entirely different target. Will it do so? As the theory goes, if a bunch of educated PhDs here in the states have difficulty engineering a soft landing in an economy whose metrics are well understood, how can a bunch of ex-communists accomplish that in a wild west version? Well, let’s not forget that for better or worse, most of the economists and analysts manning the PBC were educated in the West—in the finest graduate schools, no less. So what we can expect to see in Chinese economic policy probably wont be much different from what a western Keynesian or monetarist would espouse. That’s not to say they will get it right (as certainly economists here seldom do) but let’s not assume they will just be shooting from the hip either. There are lots of tools to accomplish their objective, short of raising interest rates (as we have seen with the reserve rate hike, for example). In our opinion, there most likely will be rate hikes to come in China but they will be modest, measured and well telegraphed. And the PBC will put forward other programs to slow real estate speculation, as they already have. That’s a page from our own Federal Reserve’s manual, something the Chinese have long studied. And if we are right and food inflation moderates, perhaps the cycle of tightening might be much shorter than most forecasters expect. That would be good news for the world economy and, of course, the world’s equity markets.
Tuesday, November 23, 2010
Ramblings of a Portfolio Manager
And They All Said QE2 Would Fail.
In this holiday-shortened week we thought it only appropriate to publish a holiday-shortened Ramblings. With all the crises around the world, why do we eschew addressing the global troubles in depth? Alfred E. Newman comes to mind. “What? Me worry?”
It’s Tuesday. Let us briefly recount the global fears of the week so far: 1. China is going to tighten itself into a recession. 2. Ditto for Hong Kong. 3. Ireland is either going to sink into the Ocean or go to the Greens (why not? it is the Emerald Isle) 4. The rest of the PIGS are going to be taken down by Ireland. 5. The SEC, seeking to burnish its image post Bernie Madoff, is going to destroy the US financial system and 6. Just in, North Korea took a few pot shots at South Korea, causing the Japanese Prime Minister to suggest that war might ensue. Just another week in the richly diverse ecosphere that we call mother Earth (makes you wonder where all those hand-holding, Coke-holding kids singing on the mountain top went). So why are we adopting a c’est la vie attitude toward it all, just two days from Thanksgiving in the US? Exactly.
We’re not big movie buffs but we’ve seen all these titles before—some more times than our kids have watched the Spongebob Movie (ugh). So, let’s close our eyes and describe that film, scene by scene. 1. The pundits tell us that China is either a fraud or a bubble. Get your story straight and we’ll decide whether or not to start worrying. Meanwhile, we’ll take 9+% growth and p/e ratios on their ADRs of 5x or less. 2. What is Hong Kong and why do we care if their property market cools? Do they buy anything from us, or from anyone else for that matter? They’re an exporter—actually, a re-exporter, turning around products from the Mainland and shipping them worldwide. If anything, cheaper land there means more arable property on which to grow bamboo for chop sticks. That sounds good for the US. 3. The IMF and EU have Ireland under control. Yes, we know they are all wine-drinking socialists but they are acting fast (unlike what they did with Greece) and with determination. They have everything at stake to save the EU and the Euro and they will do so or die. 4. We’re tired of hearing about the PIGS. The only thing they all have in common is the aforementioned affinity for wine. Not a recipe for contagion. 5. No-one kicked in our door looking for files yesterday. Goldman will pay another $half billion to the SEC to make things go away. So will dozens of other wealthy hedge funds and, after the obligatory “perp walks” blazoned across the TV screens over the next week or so, we will hear nothing more about this—certainly nothing about what the Treasury will do with all that money it will collect from settlements. 6. South Korea is very, very limited by treaty in the response it can take with the North. Over the years we’ve seen shots fired across the border, ships and subs sunk, missiles fired and countless other antagonistic actions, all without serious repercussion. The reality is that the Russians don’t want them fighting, the Chinese don’t want them fighting and the US doesn’t want them fighting. They will not fight. Besides, battle hardened Hillary is on the case.
We like turkey and we like thanksgiving buffets. Our favorite buffet, at $40/head for kids, $75 for adults, was booked months in advance and is no longer taking wait list candidates. Meanwhile, we can’t get that Lego Harry Potter set for the kids because Amazon is already sold out of the $140 toy. The dumb bunny on CNBC (it’s just too pat that her IQ is double digits and, literally, her last name means rabbit) at 4am just told us that EU Consumer Confidence and PMI both beat expectations and that US retail sales are already coming in stronger than expected. Expectations for Black Friday in the US get ramped up every day. Of course, all that information will probably soon be deemed insider information but, in the meantime, we call it empirical research and it tells us that things just aint so bad, even here.
“Risk on, Risk off” in the markets, says the dumb bunny. We wonder if she understands how hard it is to hedge and unhedge a $5bn portfolio overnight--even with options and ETFs—as if any responsible manager would do that in response to a headline, even if permitted by mandate, after every financial instrument has already reacted accordingly. Meanwhile, amid all this “turmoil” the worry warts and hand wringers will do the “Risk off” trade and sell their stocks and go back into the Dollar and US Treasuries as a safe haven. Heck, they’ll probably buy some really cheap gold while they’re at it. And as they do, Mr. Bernanke will thank them for making his work on QE2 so much easier and potentially more successful and we thank them for another opportunity to get some good multinationals on the cheap. So much to be thankful for. Gobble Gobble.
Happy Thanksgiving!
In this holiday-shortened week we thought it only appropriate to publish a holiday-shortened Ramblings. With all the crises around the world, why do we eschew addressing the global troubles in depth? Alfred E. Newman comes to mind. “What? Me worry?”
It’s Tuesday. Let us briefly recount the global fears of the week so far: 1. China is going to tighten itself into a recession. 2. Ditto for Hong Kong. 3. Ireland is either going to sink into the Ocean or go to the Greens (why not? it is the Emerald Isle) 4. The rest of the PIGS are going to be taken down by Ireland. 5. The SEC, seeking to burnish its image post Bernie Madoff, is going to destroy the US financial system and 6. Just in, North Korea took a few pot shots at South Korea, causing the Japanese Prime Minister to suggest that war might ensue. Just another week in the richly diverse ecosphere that we call mother Earth (makes you wonder where all those hand-holding, Coke-holding kids singing on the mountain top went). So why are we adopting a c’est la vie attitude toward it all, just two days from Thanksgiving in the US? Exactly.
We’re not big movie buffs but we’ve seen all these titles before—some more times than our kids have watched the Spongebob Movie (ugh). So, let’s close our eyes and describe that film, scene by scene. 1. The pundits tell us that China is either a fraud or a bubble. Get your story straight and we’ll decide whether or not to start worrying. Meanwhile, we’ll take 9+% growth and p/e ratios on their ADRs of 5x or less. 2. What is Hong Kong and why do we care if their property market cools? Do they buy anything from us, or from anyone else for that matter? They’re an exporter—actually, a re-exporter, turning around products from the Mainland and shipping them worldwide. If anything, cheaper land there means more arable property on which to grow bamboo for chop sticks. That sounds good for the US. 3. The IMF and EU have Ireland under control. Yes, we know they are all wine-drinking socialists but they are acting fast (unlike what they did with Greece) and with determination. They have everything at stake to save the EU and the Euro and they will do so or die. 4. We’re tired of hearing about the PIGS. The only thing they all have in common is the aforementioned affinity for wine. Not a recipe for contagion. 5. No-one kicked in our door looking for files yesterday. Goldman will pay another $half billion to the SEC to make things go away. So will dozens of other wealthy hedge funds and, after the obligatory “perp walks” blazoned across the TV screens over the next week or so, we will hear nothing more about this—certainly nothing about what the Treasury will do with all that money it will collect from settlements. 6. South Korea is very, very limited by treaty in the response it can take with the North. Over the years we’ve seen shots fired across the border, ships and subs sunk, missiles fired and countless other antagonistic actions, all without serious repercussion. The reality is that the Russians don’t want them fighting, the Chinese don’t want them fighting and the US doesn’t want them fighting. They will not fight. Besides, battle hardened Hillary is on the case.
We like turkey and we like thanksgiving buffets. Our favorite buffet, at $40/head for kids, $75 for adults, was booked months in advance and is no longer taking wait list candidates. Meanwhile, we can’t get that Lego Harry Potter set for the kids because Amazon is already sold out of the $140 toy. The dumb bunny on CNBC (it’s just too pat that her IQ is double digits and, literally, her last name means rabbit) at 4am just told us that EU Consumer Confidence and PMI both beat expectations and that US retail sales are already coming in stronger than expected. Expectations for Black Friday in the US get ramped up every day. Of course, all that information will probably soon be deemed insider information but, in the meantime, we call it empirical research and it tells us that things just aint so bad, even here.
“Risk on, Risk off” in the markets, says the dumb bunny. We wonder if she understands how hard it is to hedge and unhedge a $5bn portfolio overnight--even with options and ETFs—as if any responsible manager would do that in response to a headline, even if permitted by mandate, after every financial instrument has already reacted accordingly. Meanwhile, amid all this “turmoil” the worry warts and hand wringers will do the “Risk off” trade and sell their stocks and go back into the Dollar and US Treasuries as a safe haven. Heck, they’ll probably buy some really cheap gold while they’re at it. And as they do, Mr. Bernanke will thank them for making his work on QE2 so much easier and potentially more successful and we thank them for another opportunity to get some good multinationals on the cheap. So much to be thankful for. Gobble Gobble.
Happy Thanksgiving!
Wednesday, November 17, 2010
Ramblings of a Portfolio Manager
News Flash: Lincoln Shot. South May Rise Again. Hide in Your Root Cellar and Don’t Forget Your Musket
It has always amused us that, while we operate in a stock market deemed highly efficient by the economists and other smarter-than-us PhD types, the same news tends to discounted once, twice, even three times chronologically though the contents and substance of that news package never changes. Take for example a negative preannouncement by a company—Management typically lays out a narrow EPS and revenue range expected to be reported for the quarter gone by, gives full reason for the miss and often gives a narrow projection for the next quarter and the rest of the year. And Wall Street, ever the immediate discounting mechanism (some might say spoiled child not getting its way) will send the stock post-haste to the nether worlds of price and valuation. But that price reaction doesn’t provide a great bargain hunting opportunity for value investors—for, 9 times out of ten (our back of the envelope observation), when that same company reports the exact same news on the originally planned reporting date, the geniuses in portfolio management will engender the same reaction for the same reason. And, God forbid, the company tapes the call and offers it up to those missing the original, we can fully expect the markets to put the stock in the penalty box yet again until the tape is pulled from the web. So much for the Efficient Market Theory.
But that’s all anecdotal evidence (although we are doing some home work on this phenomenon) on individual company reports. What has really gotten our goat (literally) is the markets’ reaction to the “same old same old” vis-à-vis European debt crisis—i.e the PIGS. Personally, we thought we had slaughtered those pigs months ago. Remember when the dollar was to reach parity with the Euro back in May? It was all due to weakness in the PIGS. Remember when commodities and exporters were crushed because a stronger dollar would hurt their sales and earnings? That was the talk back in May. Remember when a weakened Europe would engender a double-dip here in the US? That was back in May as well. Let’s examine that happened and rate the economists’ dire predictions: First, the Euro, instead of hitting parity versus the dollar, climbed steadily to nearly 1,50/1,00 (we intentionally used commas to look cool and Euro). US multinationals, instead of reporting weaker international sales, consistently beat estimates solely bases on European strength and are on fire. Greece, whom Long Island can kick in a rumble, seem settled; Portugal and Spain, larger than Greece but still a speck on the screen, were tamed and sent away with strong assurances. All markets moved up as a result. Meanwhile, ever looking back into the rear view mirror, the Fed decided to launch QE2 in response as an insurance policy, a move which initially sent the US markets into a roil because it was interpreted at the Fed knowing something negative about domestic economic weakness that the rest of us mere mortals did not. In short, none of the dire consequence have occurred and, in fact, things have gotten much, much better on both sides of the shore since May. Yup, the economists got it wrong again. Surprised?
So, here we are again, markets in turmoil, dollar rising versus the Euro, commodities and multi-nationals in the shit can and a host of pundits thinking maybe a double dip might be back n the front burner. The amusingly hypocritical part of it all is that many of those pundits, who at first lauded QE2, then begged for it, are now on the lecture tour panning the whole idea because it could cause—heavens to Betsy—inflation! All based on a few stronger than expected reports from the US economy. What, exactly did those pundits think was the intent of the program? Funny case is that Greece is somehow back in the mix (they are fixing their problem but not as fast as the Austrians or Greenwhich PMs would like). All that’s missing is the goat negotiating the riots. Perhaps Greece would like to lend the goat to the French—they could use a little humor in their seemingly constant parade of protests (we lost count of the myriad reasons years ago--we did too). The goat may also make them feel better about their personal hygiene.
Oh, we forgot China. Things seem to be so strong there economically that they continue to put the brakes on their own economy, hoping to stave off inflation. One pundit we haven’t heard from is Jim Chanos of Kynikos. Smart guy but it was is contention at the beginning of the year that China was in a bubble but at the same time was intentionally over-forecasting its economic strength? Huh? For his sake we hope he covered his shorts before the recent meteoric rise in the Shanghai index.
The Dow, S&P, NASDAQ and Russell have all lost 5+% plus in the last week or so. Partially on the back of Europe, partially due to China and a fair amount based on post-election blues. Is this the correction/pullback/consolidation that the technicians have been calling for? Notice that, long absent from the Tube, they are now back on again, all with a universal call for a drop of anywhere from 3% (done) to 50% (uh huh). Our answer, or question rather, is “what has changed in the global macroeconomic environment since April.” In fact, things have gotten better economically in the world with many of the global imbalances beginning to self correct (no disrespects to the central banks).
Michael Steinhart was on CNBC yesterday calling this price action temporary and based on information already discounted by the market. We tend to agree. Though he is light years smarter than we, we both look at the market from a bottoms up perspective—that is, companies and markets first, then look at what’s going on the world and how it may affect those companies.
And for all those wringing their hands about pending inflation, if you really believe your own PR, sell you Treasuries before you become a casualty. And remember that inflation is good for commodities. The Fed has gone from savior to villain based on your naive concept of what causes inflation (its employment costs, not interest rates per se). So when we reach full employment and the S&P is 500 points higher as a result, look at your depleted bond fund and remember that you were warned.
It has always amused us that, while we operate in a stock market deemed highly efficient by the economists and other smarter-than-us PhD types, the same news tends to discounted once, twice, even three times chronologically though the contents and substance of that news package never changes. Take for example a negative preannouncement by a company—Management typically lays out a narrow EPS and revenue range expected to be reported for the quarter gone by, gives full reason for the miss and often gives a narrow projection for the next quarter and the rest of the year. And Wall Street, ever the immediate discounting mechanism (some might say spoiled child not getting its way) will send the stock post-haste to the nether worlds of price and valuation. But that price reaction doesn’t provide a great bargain hunting opportunity for value investors—for, 9 times out of ten (our back of the envelope observation), when that same company reports the exact same news on the originally planned reporting date, the geniuses in portfolio management will engender the same reaction for the same reason. And, God forbid, the company tapes the call and offers it up to those missing the original, we can fully expect the markets to put the stock in the penalty box yet again until the tape is pulled from the web. So much for the Efficient Market Theory.
But that’s all anecdotal evidence (although we are doing some home work on this phenomenon) on individual company reports. What has really gotten our goat (literally) is the markets’ reaction to the “same old same old” vis-à-vis European debt crisis—i.e the PIGS. Personally, we thought we had slaughtered those pigs months ago. Remember when the dollar was to reach parity with the Euro back in May? It was all due to weakness in the PIGS. Remember when commodities and exporters were crushed because a stronger dollar would hurt their sales and earnings? That was the talk back in May. Remember when a weakened Europe would engender a double-dip here in the US? That was back in May as well. Let’s examine that happened and rate the economists’ dire predictions: First, the Euro, instead of hitting parity versus the dollar, climbed steadily to nearly 1,50/1,00 (we intentionally used commas to look cool and Euro). US multinationals, instead of reporting weaker international sales, consistently beat estimates solely bases on European strength and are on fire. Greece, whom Long Island can kick in a rumble, seem settled; Portugal and Spain, larger than Greece but still a speck on the screen, were tamed and sent away with strong assurances. All markets moved up as a result. Meanwhile, ever looking back into the rear view mirror, the Fed decided to launch QE2 in response as an insurance policy, a move which initially sent the US markets into a roil because it was interpreted at the Fed knowing something negative about domestic economic weakness that the rest of us mere mortals did not. In short, none of the dire consequence have occurred and, in fact, things have gotten much, much better on both sides of the shore since May. Yup, the economists got it wrong again. Surprised?
So, here we are again, markets in turmoil, dollar rising versus the Euro, commodities and multi-nationals in the shit can and a host of pundits thinking maybe a double dip might be back n the front burner. The amusingly hypocritical part of it all is that many of those pundits, who at first lauded QE2, then begged for it, are now on the lecture tour panning the whole idea because it could cause—heavens to Betsy—inflation! All based on a few stronger than expected reports from the US economy. What, exactly did those pundits think was the intent of the program? Funny case is that Greece is somehow back in the mix (they are fixing their problem but not as fast as the Austrians or Greenwhich PMs would like). All that’s missing is the goat negotiating the riots. Perhaps Greece would like to lend the goat to the French—they could use a little humor in their seemingly constant parade of protests (we lost count of the myriad reasons years ago--we did too). The goat may also make them feel better about their personal hygiene.
Oh, we forgot China. Things seem to be so strong there economically that they continue to put the brakes on their own economy, hoping to stave off inflation. One pundit we haven’t heard from is Jim Chanos of Kynikos. Smart guy but it was is contention at the beginning of the year that China was in a bubble but at the same time was intentionally over-forecasting its economic strength? Huh? For his sake we hope he covered his shorts before the recent meteoric rise in the Shanghai index.
The Dow, S&P, NASDAQ and Russell have all lost 5+% plus in the last week or so. Partially on the back of Europe, partially due to China and a fair amount based on post-election blues. Is this the correction/pullback/consolidation that the technicians have been calling for? Notice that, long absent from the Tube, they are now back on again, all with a universal call for a drop of anywhere from 3% (done) to 50% (uh huh). Our answer, or question rather, is “what has changed in the global macroeconomic environment since April.” In fact, things have gotten better economically in the world with many of the global imbalances beginning to self correct (no disrespects to the central banks).
Michael Steinhart was on CNBC yesterday calling this price action temporary and based on information already discounted by the market. We tend to agree. Though he is light years smarter than we, we both look at the market from a bottoms up perspective—that is, companies and markets first, then look at what’s going on the world and how it may affect those companies.
And for all those wringing their hands about pending inflation, if you really believe your own PR, sell you Treasuries before you become a casualty. And remember that inflation is good for commodities. The Fed has gone from savior to villain based on your naive concept of what causes inflation (its employment costs, not interest rates per se). So when we reach full employment and the S&P is 500 points higher as a result, look at your depleted bond fund and remember that you were warned.
Monday, November 8, 2010
Ramblings of a Portfolio Manager
The Neville Chamberlain Market?
The mid-term elections are over and they largely went the way of consensus with Republicans re-taking a majority in the House of Representatives and making inroads into, but not capturing, the Senate. The equity markets, ever the discounting mechanism, read the late polls and bid the market higher ahead of the actual results, leading us to believe that those results were indeed fully discounted on November 3rd. And like many observers, we expected some sell on the news action on that day, albeit shallower and quicker than the bevy of analysts in the financial media were predicting, primarily because that was what the bevy of analysts in the financial media were predicting. But then something happened that the skeptics, including ourselves, weren’t expecting: a quadruple of headlines that seemed to come from the equity owners’ Christmas wish list hit the tape. The sell on the news reaction, whether it was indeed a discounted discounting or actually responding to these headlines, turned out indeed to be shallow and quick. In fact, the “dip” lasted approximately a half a day.
The equity markets started strong the morning of November 3rd on post-election euphoria, even though some of the Market’s most wanted “villains” (e.g. Harry Reid and Barney Frank) survived the Democratic drubbing. The Market’s Santa list item #1 was soon delivered by President Obama, who appeared on TV to make what sounded to all like a conciliatory concession speech. In fact, the President sounded downright humble, if not contrite, in his pronouncement that he had learned from the “shellacking” the Democrats took on Tuesday. To many, that sounded so reminiscent of Clinton’s move to the Center after his first mid-terms that the Market rose even higher--but equities soon began to weaken as the Federal Reserve’s pronouncement on the size of QE2 drew near. While the markets earlier had initially expected close to $1Trillion in easing, a Wall Street Journal article late in October cut that expectation in half, to $500 million and there was unease that the announced number could be even lower. Santa list item #2, however, came around 2:15pm with the Fed announcing $600mm in expected easing with the potential for more to come if needed. The market’s reaction was swift and powerful, with the Dow gaining over a hundred points from its lows in about 2 seconds. Bonds sold off as rates rose in anticipation of a stronger economy down the road. Yet for all Wednesday’s volatility and drama, the markets closed the day essentially flat with many investors unsure what to make of the news they had just digested.
That was Wednesday and it seems that investors’ digestion period lasted exactly overnight. Thursday morning awoke to strong equity futures followed by a correspondingly strong opening to the US markets. Why? In our view, there were just too many people on the sidelines waiting for the post-election selloff to get back into the market (or cover shorts). When it didn’t occur on Wednesday, they panicked and jumped in feet first on Thursday. But Santa list item #3 was about to be released—that is, the unbelievable statement from President Obama that he was willing to consider extending the Bush tax cuts to all income classes—something about which he was adamantly negative pre-election. That pronouncement was the icing on the cake for the “move to the Center” crowd and the market rallied right into the close and by the end of the day the Dow and S&P 500 had closed up 2% while the Russell 2000, a proxy for risk taking, closed up 2.6%. The final Santa wish list item came on Friday with a jobs’ report that showed new jobs created over twice the consensus estimate. All combined, with the delivery of the Christmas list, the US equity markets closed the week with a 2.9% gain on the Dow, a 3.6% gain on the S&P 500 and a 4.7% return on the Russell 2000. Not a bad week considering that the consensus was for a big sell off.
So now that the big catalysts are behind us, with a few surprises thrown in, what can we expect from the equity markets for the rest of the year and into the next? In our opinion, it all boils down to the credibility of the President and the Federal Reserve. It was clear that Obama was doing a fair amount of public eating crow last week and much of it was for PR purposes--but if he stays true to his word on taxes and working with the new majority, we could see further gains ahead. The same holds true for Bernanke. If, indeed, the Fed is good for its $600+mm number, then rates can stay relatively low and the equity markets can continue to rally. But, as a former British Prime Minister discovered over 70 years ago, dealing with politicians can be a tricky affair. It’s not that they lie but they often “misspeak.” So we will keep our ears and eyes open to see if this market is expanding into fictitious Lebensraum or if, indeed, it is soaring on the wings of crows.
The mid-term elections are over and they largely went the way of consensus with Republicans re-taking a majority in the House of Representatives and making inroads into, but not capturing, the Senate. The equity markets, ever the discounting mechanism, read the late polls and bid the market higher ahead of the actual results, leading us to believe that those results were indeed fully discounted on November 3rd. And like many observers, we expected some sell on the news action on that day, albeit shallower and quicker than the bevy of analysts in the financial media were predicting, primarily because that was what the bevy of analysts in the financial media were predicting. But then something happened that the skeptics, including ourselves, weren’t expecting: a quadruple of headlines that seemed to come from the equity owners’ Christmas wish list hit the tape. The sell on the news reaction, whether it was indeed a discounted discounting or actually responding to these headlines, turned out indeed to be shallow and quick. In fact, the “dip” lasted approximately a half a day.
The equity markets started strong the morning of November 3rd on post-election euphoria, even though some of the Market’s most wanted “villains” (e.g. Harry Reid and Barney Frank) survived the Democratic drubbing. The Market’s Santa list item #1 was soon delivered by President Obama, who appeared on TV to make what sounded to all like a conciliatory concession speech. In fact, the President sounded downright humble, if not contrite, in his pronouncement that he had learned from the “shellacking” the Democrats took on Tuesday. To many, that sounded so reminiscent of Clinton’s move to the Center after his first mid-terms that the Market rose even higher--but equities soon began to weaken as the Federal Reserve’s pronouncement on the size of QE2 drew near. While the markets earlier had initially expected close to $1Trillion in easing, a Wall Street Journal article late in October cut that expectation in half, to $500 million and there was unease that the announced number could be even lower. Santa list item #2, however, came around 2:15pm with the Fed announcing $600mm in expected easing with the potential for more to come if needed. The market’s reaction was swift and powerful, with the Dow gaining over a hundred points from its lows in about 2 seconds. Bonds sold off as rates rose in anticipation of a stronger economy down the road. Yet for all Wednesday’s volatility and drama, the markets closed the day essentially flat with many investors unsure what to make of the news they had just digested.
That was Wednesday and it seems that investors’ digestion period lasted exactly overnight. Thursday morning awoke to strong equity futures followed by a correspondingly strong opening to the US markets. Why? In our view, there were just too many people on the sidelines waiting for the post-election selloff to get back into the market (or cover shorts). When it didn’t occur on Wednesday, they panicked and jumped in feet first on Thursday. But Santa list item #3 was about to be released—that is, the unbelievable statement from President Obama that he was willing to consider extending the Bush tax cuts to all income classes—something about which he was adamantly negative pre-election. That pronouncement was the icing on the cake for the “move to the Center” crowd and the market rallied right into the close and by the end of the day the Dow and S&P 500 had closed up 2% while the Russell 2000, a proxy for risk taking, closed up 2.6%. The final Santa wish list item came on Friday with a jobs’ report that showed new jobs created over twice the consensus estimate. All combined, with the delivery of the Christmas list, the US equity markets closed the week with a 2.9% gain on the Dow, a 3.6% gain on the S&P 500 and a 4.7% return on the Russell 2000. Not a bad week considering that the consensus was for a big sell off.
So now that the big catalysts are behind us, with a few surprises thrown in, what can we expect from the equity markets for the rest of the year and into the next? In our opinion, it all boils down to the credibility of the President and the Federal Reserve. It was clear that Obama was doing a fair amount of public eating crow last week and much of it was for PR purposes--but if he stays true to his word on taxes and working with the new majority, we could see further gains ahead. The same holds true for Bernanke. If, indeed, the Fed is good for its $600+mm number, then rates can stay relatively low and the equity markets can continue to rally. But, as a former British Prime Minister discovered over 70 years ago, dealing with politicians can be a tricky affair. It’s not that they lie but they often “misspeak.” So we will keep our ears and eyes open to see if this market is expanding into fictitious Lebensraum or if, indeed, it is soaring on the wings of crows.
Tuesday, October 26, 2010
Ramblings of a Portfolio Manager
The Cake is Baked. So What’s the Icing?
We’ve been postulating for weeks now that the mid-term elections have already been discounted by the equity markets. That is, the equity markets’ 12+% rise from their late August bottom has been due, in part, to expectations of a Republican retake of the majority vote in the House of Representatives. But election euphoria alone hasn’t done all the work--the other factor contributing to the markets’ rise, we have been proposing, has been the expectation of the initiation of QE2 in November and that, therefore, is also discounted to some degree. In fact, these two “events” have been the principal drivers of this market now for almost two months, all in the face of continued weak economic data. Expectations for the mid-terms probably got it all started and QE2, which has brought the US Dollar to a 15 year low versus most major currencies, has been doing the heavy lifting, acting as the support and continuing driver to equities. In fact, the US market indices now slavishly move in reverse lockstep to the dollar’s strength or weakness, ignoring economic data, earnings reports, or any other fundamental data related to their constituent companies. So, with the two big catalysts already baked into the cake, so to speak, what’s left to drive the equity markets to the end of the year?
According to our research, gleaned from multiple sources, since 1922 the average fourth quarter rise in the Dow in a mid-term election year is 8.5%. In fact, there were only two times when the equity markets were not higher in the 90 days following a mid-term election and in both situations the Fed was actively raising rates in an attempt to reign in the economy. Given October’s performance to date, we’re already half way to the average. But this has been a year of historic swings—worst May since the 50’s, best September since the 30’s, etc. etc. Have we already gotten half the expected gains for Q4? We don’t think so. There are several drivers still remaining, which have not been fully discounted by the markets. The first is a Republican retake of the Senate as well. Polls are notoriously inaccurate but many show this as a possibility. Would it drive stocks higher? We think so. In fact, we are beginning to believe that political “gridlock,” usually so good for the markets, may be a detriment this time around. Much of what has been suppressing the economy, and thus the markets, over the last year-and-a-half have been the onerous bills passed by the current Congress—Health Care and Financial Reform. With gridlock, these two items will most likely persist, unmodified. With a Republican mandate in both the House and Senate, there is a fair chance that they will be lightened up to the benefit of business or, better yet, go away altogether.
Another driver we see is the size of QE2. Right now it is difficult to find a portfolio manager appearing on TV who doesn’t believe that QE2 will be anything less than $1Trillion but there are still some skeptics. We think the Fed is listening and doesn’t wish to rock the equity markets, which it is attempting to lift to spur the wealth effect. Therefore, we believe that the minimum amount of the easing will be $1trillion. Anything more and the dollar will plummet further, with the markets off to the races.
Finally, there is—gasp--fundamentals and valuation. Does anyone pay attention to those anymore? We think investors will start doing so again, particularly if the “government overhang” is eliminated in the mid-terms. Right now First Call is looking for $92+ in S&P500 earnings for 2011—that’s a 14% rise from this year’s estimates, ¾ of which are “in the bag” with the remaining quarters inching higher as this earnings season progresses. That puts the S&P at 12.8x forward earnings, a decade low. And with those earnings estimates poised to rise with renewed confidence and guidance from Company Management (again, post elections), we may well see a market that not only grows along with earnings (just like the good old days) but gets some long awaited multiple expansion. Given this and the “icings’ mentioned above, we believe Q4 and 2011 will be sweet for equity investors indeed.
We’ve been postulating for weeks now that the mid-term elections have already been discounted by the equity markets. That is, the equity markets’ 12+% rise from their late August bottom has been due, in part, to expectations of a Republican retake of the majority vote in the House of Representatives. But election euphoria alone hasn’t done all the work--the other factor contributing to the markets’ rise, we have been proposing, has been the expectation of the initiation of QE2 in November and that, therefore, is also discounted to some degree. In fact, these two “events” have been the principal drivers of this market now for almost two months, all in the face of continued weak economic data. Expectations for the mid-terms probably got it all started and QE2, which has brought the US Dollar to a 15 year low versus most major currencies, has been doing the heavy lifting, acting as the support and continuing driver to equities. In fact, the US market indices now slavishly move in reverse lockstep to the dollar’s strength or weakness, ignoring economic data, earnings reports, or any other fundamental data related to their constituent companies. So, with the two big catalysts already baked into the cake, so to speak, what’s left to drive the equity markets to the end of the year?
According to our research, gleaned from multiple sources, since 1922 the average fourth quarter rise in the Dow in a mid-term election year is 8.5%. In fact, there were only two times when the equity markets were not higher in the 90 days following a mid-term election and in both situations the Fed was actively raising rates in an attempt to reign in the economy. Given October’s performance to date, we’re already half way to the average. But this has been a year of historic swings—worst May since the 50’s, best September since the 30’s, etc. etc. Have we already gotten half the expected gains for Q4? We don’t think so. There are several drivers still remaining, which have not been fully discounted by the markets. The first is a Republican retake of the Senate as well. Polls are notoriously inaccurate but many show this as a possibility. Would it drive stocks higher? We think so. In fact, we are beginning to believe that political “gridlock,” usually so good for the markets, may be a detriment this time around. Much of what has been suppressing the economy, and thus the markets, over the last year-and-a-half have been the onerous bills passed by the current Congress—Health Care and Financial Reform. With gridlock, these two items will most likely persist, unmodified. With a Republican mandate in both the House and Senate, there is a fair chance that they will be lightened up to the benefit of business or, better yet, go away altogether.
Another driver we see is the size of QE2. Right now it is difficult to find a portfolio manager appearing on TV who doesn’t believe that QE2 will be anything less than $1Trillion but there are still some skeptics. We think the Fed is listening and doesn’t wish to rock the equity markets, which it is attempting to lift to spur the wealth effect. Therefore, we believe that the minimum amount of the easing will be $1trillion. Anything more and the dollar will plummet further, with the markets off to the races.
Finally, there is—gasp--fundamentals and valuation. Does anyone pay attention to those anymore? We think investors will start doing so again, particularly if the “government overhang” is eliminated in the mid-terms. Right now First Call is looking for $92+ in S&P500 earnings for 2011—that’s a 14% rise from this year’s estimates, ¾ of which are “in the bag” with the remaining quarters inching higher as this earnings season progresses. That puts the S&P at 12.8x forward earnings, a decade low. And with those earnings estimates poised to rise with renewed confidence and guidance from Company Management (again, post elections), we may well see a market that not only grows along with earnings (just like the good old days) but gets some long awaited multiple expansion. Given this and the “icings’ mentioned above, we believe Q4 and 2011 will be sweet for equity investors indeed.
Monday, October 18, 2010
Ramblings of a Portfolio Manager
The QE2 is Setting Sail to New York. So Why Were All The Passengers Wearing Sombreros and Blowing Didgeridoos?
Ben Bernanke gave his much anticipated speech regarding the Fed’s propensity to reinitiate Quantitative Easing at an FOMC-sponsored Conference in Boston last Friday. The speech was intended to give insight into the probabilities of the FOMC announcing a resumption of Quantitative Easing (dubbed QE2) at its November meeting. In his remarks, Bernanke said inflation is currently too low and the unemployment rate is too high given the central bank’s dual mandate of maximum economic growth and price stability: He made a case for new Fed action to boost growth, saying inflation is running below the Fed's objective of 2% and that the economy is growing too slowly to reduce unemployment. But he also cautioned that there were costs associated with the policy as well as benefits and the Fed had much less experience in judging the economic effects of asset purchases, “which makes it challenging to determine the appropriate quantity and pace of purchases and to communicate this policy response to the public.” He went on to say that “These factors have dictated that the FOMC proceed with some caution in deciding whether to engage in further purchases of longer-term securities.” “Even though the conditions are in place for growth to pick up next year,” he said, “high unemployment and low inflation will probably linger.” “Given the FOMC’s objectives, there would appear -- all else being equal -- to be a case for further action.” Sometimes, around here, we miss the cryptic ramblings of Alan Greenspan. At least, under all that enigmatic Fed Speak, there was a definitive answer to the Fed’s next course of action. One just needed his Captain America decoder ring and a Cray XT-3 with language processing software and all was clear.
There was much economic data released on the day Bernanke spoke but the markets reacted almost solely to the Chairman’s words and the speech was greeted with little more than a yawn by the equity markets. Initially it gave a mild boost to equities and took some of the steam out of Gold. But Bernanke said very little that the markets were not already anticipating--since the Chairman outlined the potential second round of quantitative easing during an Aug. 27 speech in Jackson Hole, global equities have climbed 14.1% and commodities have gained 13.1%--and by the end of the day most equity markets were down and Gold had recovered some of its losses. The dollar, however, turned higher against the Euro and a basket of major currencies, but was still down broadly for the week. The interesting price action came in the 30-year Treasury bond where the bonds slumped, driving the yield up 18 basis points to just under 4.0% for the week. That’s a big jump in long rates from their September lows in the 3.5% range. Why the seemingly perverse reaction to an announcement by the Chairman of the FOMC that the Federal Reserve would begin a program of attempting to hold down long-term rates for a very long time?
We have been tracking street expectations for QE2 since the initial announcement in August. Since the markets began to digest that the Federal Reserve was serious in its plans, expectations for the timing and size of the operation have continually grown. By our analysis, there is now little market doubt that the FOMC will launch QE2 at the November meeting. Expectations range from $500 Billion to a $1 Trillion program, with some as high as $1.5 Trillion. Such a large disparity of viewpoints is a clear indication that the FOMC has done a poor job communicating its policies and managing market expectations. In fact, the way we see it, the FOMC has probably let expectations run too high and has created a situation where the current actions we have seen in financial markets are being driven almost entirely by QE2 expectations. The Fed, in essence, have painted themselves into a corner whereby there will be a negative reaction in equities, currencies and bonds if the markets’ expectations are not met.
So what will be the size of QE2 and will it work? Bernanke called the first purchases of $1.7 trillion in mostly housing-related assets successful. There are a range of opinions on the FOMC about the method of further asset purchases, and the details will be hashed out at the FOMC’s next meeting on Nov. 2-3. The market’s focus, however, will be “how much?” From our work it would appear anything short of $1.0 Trillion in QE2 would disappoint both equity and currency watchers.
But the markets’ trepidations go beyond the final amount of the QE2. The big fear, for many experienced investors, is whether the Fed will have an adequate exit strategy and will they time it properly—i.e. will their program work too well and ignite hyperinflation before they can shut it down. That’s why bonds sold off and the dollar strengthened on Bernanke’s speech, in our opinion. The Chairman’s response was that he is confident the Fed will be able to tighten policy when warranted, even if the balance sheet is larger than normal but he also pointed out that the FOMC might consider modifying the language of its policy statement to indicate that it will keep rates “low for longer than markets expect.” At the moment, the FOMC statement is that the exceptionally low levels of the federal funds rate are likely to be warranted “for an extended period.” Remember, the target is to get inflation higher and Ben Bernanke, student of the depression, will not be the Fed Chairman who presides over a US economy in depression and with deflation if he can avoid it. So in addition to preventing deflation, we believe QE2 is intended to boost equity prices and thus, net worth and the economy in general. The question is, will the Fed cave into market expectations and target the $1.0 Trillion number?
We expect the Fed to hit the $1 Trillion number but for the perverse reaction to QE2 to continue. That is, we expect long-term rates to rise and the dollar strengthen even as the Fed begins its purchases. Why? First of all, as we noted, the markets have already priced in a significant size of QE2; long treasuries are almost certainly discounting the $1.0 Trillion number so probably don’t have much more to rise. Secondly, as the Fed injects more liquidity into the capital markets stocks will most likely rise, adding to the wealth effect. This, combined with potential strengthening confidence in the economy post mid-terms, will serve to steepen the yield curve by raising the long end, even the face of Fed purchases (its almost impossible to steepen the curve by dropping short-term rates, which are essentially zero). Finally, most missed it but Bernanke raised the Fed’s expectations for US economic growth next year. If our scenario and theirs is correct, it all points to risk in holding US fixed income securities and a rosy future for US equities. We don’t know much about them but if you’re looking to invest in fixed income, you might look toward the countries nearing the end of their tightening cycles—Brazil and Australia. Happy sailing!
Ben Bernanke gave his much anticipated speech regarding the Fed’s propensity to reinitiate Quantitative Easing at an FOMC-sponsored Conference in Boston last Friday. The speech was intended to give insight into the probabilities of the FOMC announcing a resumption of Quantitative Easing (dubbed QE2) at its November meeting. In his remarks, Bernanke said inflation is currently too low and the unemployment rate is too high given the central bank’s dual mandate of maximum economic growth and price stability: He made a case for new Fed action to boost growth, saying inflation is running below the Fed's objective of 2% and that the economy is growing too slowly to reduce unemployment. But he also cautioned that there were costs associated with the policy as well as benefits and the Fed had much less experience in judging the economic effects of asset purchases, “which makes it challenging to determine the appropriate quantity and pace of purchases and to communicate this policy response to the public.” He went on to say that “These factors have dictated that the FOMC proceed with some caution in deciding whether to engage in further purchases of longer-term securities.” “Even though the conditions are in place for growth to pick up next year,” he said, “high unemployment and low inflation will probably linger.” “Given the FOMC’s objectives, there would appear -- all else being equal -- to be a case for further action.” Sometimes, around here, we miss the cryptic ramblings of Alan Greenspan. At least, under all that enigmatic Fed Speak, there was a definitive answer to the Fed’s next course of action. One just needed his Captain America decoder ring and a Cray XT-3 with language processing software and all was clear.
There was much economic data released on the day Bernanke spoke but the markets reacted almost solely to the Chairman’s words and the speech was greeted with little more than a yawn by the equity markets. Initially it gave a mild boost to equities and took some of the steam out of Gold. But Bernanke said very little that the markets were not already anticipating--since the Chairman outlined the potential second round of quantitative easing during an Aug. 27 speech in Jackson Hole, global equities have climbed 14.1% and commodities have gained 13.1%--and by the end of the day most equity markets were down and Gold had recovered some of its losses. The dollar, however, turned higher against the Euro and a basket of major currencies, but was still down broadly for the week. The interesting price action came in the 30-year Treasury bond where the bonds slumped, driving the yield up 18 basis points to just under 4.0% for the week. That’s a big jump in long rates from their September lows in the 3.5% range. Why the seemingly perverse reaction to an announcement by the Chairman of the FOMC that the Federal Reserve would begin a program of attempting to hold down long-term rates for a very long time?
We have been tracking street expectations for QE2 since the initial announcement in August. Since the markets began to digest that the Federal Reserve was serious in its plans, expectations for the timing and size of the operation have continually grown. By our analysis, there is now little market doubt that the FOMC will launch QE2 at the November meeting. Expectations range from $500 Billion to a $1 Trillion program, with some as high as $1.5 Trillion. Such a large disparity of viewpoints is a clear indication that the FOMC has done a poor job communicating its policies and managing market expectations. In fact, the way we see it, the FOMC has probably let expectations run too high and has created a situation where the current actions we have seen in financial markets are being driven almost entirely by QE2 expectations. The Fed, in essence, have painted themselves into a corner whereby there will be a negative reaction in equities, currencies and bonds if the markets’ expectations are not met.
So what will be the size of QE2 and will it work? Bernanke called the first purchases of $1.7 trillion in mostly housing-related assets successful. There are a range of opinions on the FOMC about the method of further asset purchases, and the details will be hashed out at the FOMC’s next meeting on Nov. 2-3. The market’s focus, however, will be “how much?” From our work it would appear anything short of $1.0 Trillion in QE2 would disappoint both equity and currency watchers.
But the markets’ trepidations go beyond the final amount of the QE2. The big fear, for many experienced investors, is whether the Fed will have an adequate exit strategy and will they time it properly—i.e. will their program work too well and ignite hyperinflation before they can shut it down. That’s why bonds sold off and the dollar strengthened on Bernanke’s speech, in our opinion. The Chairman’s response was that he is confident the Fed will be able to tighten policy when warranted, even if the balance sheet is larger than normal but he also pointed out that the FOMC might consider modifying the language of its policy statement to indicate that it will keep rates “low for longer than markets expect.” At the moment, the FOMC statement is that the exceptionally low levels of the federal funds rate are likely to be warranted “for an extended period.” Remember, the target is to get inflation higher and Ben Bernanke, student of the depression, will not be the Fed Chairman who presides over a US economy in depression and with deflation if he can avoid it. So in addition to preventing deflation, we believe QE2 is intended to boost equity prices and thus, net worth and the economy in general. The question is, will the Fed cave into market expectations and target the $1.0 Trillion number?
We expect the Fed to hit the $1 Trillion number but for the perverse reaction to QE2 to continue. That is, we expect long-term rates to rise and the dollar strengthen even as the Fed begins its purchases. Why? First of all, as we noted, the markets have already priced in a significant size of QE2; long treasuries are almost certainly discounting the $1.0 Trillion number so probably don’t have much more to rise. Secondly, as the Fed injects more liquidity into the capital markets stocks will most likely rise, adding to the wealth effect. This, combined with potential strengthening confidence in the economy post mid-terms, will serve to steepen the yield curve by raising the long end, even the face of Fed purchases (its almost impossible to steepen the curve by dropping short-term rates, which are essentially zero). Finally, most missed it but Bernanke raised the Fed’s expectations for US economic growth next year. If our scenario and theirs is correct, it all points to risk in holding US fixed income securities and a rosy future for US equities. We don’t know much about them but if you’re looking to invest in fixed income, you might look toward the countries nearing the end of their tightening cycles—Brazil and Australia. Happy sailing!
Monday, October 4, 2010
Ramblings of a Portfolio Manager
Will Santa Deliver an Early Christmas Present or Will a Turkey Fall Down the Chimney?
Earnings season officially kicked off last week with the turn of the calendar, although we have already heard pre-announcements from several companies. As has been the tradition for years now, the preannouncements came ahead of the regular reporting season (by definition, duh!) and carried no particular good news—Company Management has long been cowed by litigation to release the bad news as soon as it is discovered and accurately calculated, lest they be sued for of hiding it from shareholders. So the routine, for a long time now, has been for the markets to receive the bad news first, react to that bad news (usually a negative reaction—after 15 years of Reg FD most investors still haven’t figured out this pattern!), then have the comprehensive news follow during the regular reporting season. Typically that data is better than the preannouncements (again, definitionally) and the markets react to that data depending upon its current mood. That’s certainly what happened last quarter.
We expect nothing different behaviorally for the third quarter reporting season vis-a-vis past trends. The questions, as always, are, what percentage of the reports will be negative pre-announcements, how many will match recent the urban myth of “light on revenues, better on bottom line” and what percentage will actually surpass all metrics pre-cast by the analysts? Yes, this is the question we and the markets ask every quarter, particularly since the market bottom in March 2009, but forgive us for asking it again, given its importance in market performance going forward. And besides, we wanted to get it in ahead of CNBC, which will repeat these lines at least 1543 times between now and November 15th, as always, forgetting that retailers’ reports come one month later.
So what to expect when you are expecting (royalties already paid to the baby book authors)? First, let’s explore what the few market watchers that have publicly spoken on the subject have been saying. Despite better than expected reported statistics and higher than expected guidance last quarter (which did nothing more than temporary for the markets) analysts are still calling for earnings misses and weaker guidance. Their reasoning? Q3 encompassed July and August, two critical months in the European debt crisis and the US ”soft spot.” So, naturally, the expectation is for weak results (perhaps weather than forecast) with soggy guidance (don’t they get that they, themselves, have already baked that fact into their numbers? Guess not). Sounds exactly like the forecast for Q2 earnings, the reality of which stubbornly didn’t comply. Is that how it will be again this time ‘round? And what will be the market reaction? Addressing the first question, we think not. As we have continually stressed, Company Management has learned from years of playing the “beat and raise” game to lower the bar to an appropriate level that can be easily hurdled without seeming suspicious. Nothing we heard last earnings season suggests that we will get anything different this time around—despite the beat and raise environment we had in Q2. No manager on a Q2 conference call was about to stick his neck out given the environment at the time so we feel confident that this fact, combined with the usual conservative game theory behavior in which managers quarterly participate, will produce yet another round of 70%+ earnings beats, given that analysts simply take Management numbers to form their own forecasts. What about guidance? Here again, we expect the same. In fact, the Company Management with whom we have spoken recently are getting more optimistic in light of expected mid-term regime change and may, in fact, be emboldened enough to say even more positive things about Q4 and beyond, especially on the hiring front—and this is despite the political affiliation of the manager (we always ask).
Market reaction? We’re tempted to flippantly (pun intended) suggest one “flip a coin.” Even though the expectations are for weak reports and guidance, the opposite may not have the expected reaction in equity prices. They didn’t, on net, during Q2 (July having been taken back in August) so what has changed that will produce a different result in October? Well, for one thing, the [very] long term data suggest that better than expected earnings reports and guidance produce stock price gains overall and alpha specifically for those companies producing it. A couple of quarters during which the markets are in a sour mood and choose to ignore that fact are statistically insignificant. This doesn’t mean October will fall in line with history, however. What we believe will give the markets a boost on better earnings in the next few months is rising investor optimism. When Q2 earnings were reported in July, investor sentiment could not have been worse and even though we got a temporary run in stock prices, the tug-of-war with macro economic data ended with macro winning and tamping down the enthusiasm and, thus, stock prices. But this quarter is different. We have investors looking optimistically toward the upcoming elections, others looking at their underperformance and realizing that further investments in 10-year Treasuries just aint gonna beat the competition, and still others looking at 2011 as the year Obama’s damage is softened by a new congress while the economy continues to heal on its own. Like us, this last group has seen productivity gains slow and capacity utilization additional reach cap-ex levels, and both recognize this means jobs and further economic growth down the road.
So, to answer our own headline question, we thing Santa comes early this year and that the turkeys will be sucking gravy come earnings season.
Earnings season officially kicked off last week with the turn of the calendar, although we have already heard pre-announcements from several companies. As has been the tradition for years now, the preannouncements came ahead of the regular reporting season (by definition, duh!) and carried no particular good news—Company Management has long been cowed by litigation to release the bad news as soon as it is discovered and accurately calculated, lest they be sued for of hiding it from shareholders. So the routine, for a long time now, has been for the markets to receive the bad news first, react to that bad news (usually a negative reaction—after 15 years of Reg FD most investors still haven’t figured out this pattern!), then have the comprehensive news follow during the regular reporting season. Typically that data is better than the preannouncements (again, definitionally) and the markets react to that data depending upon its current mood. That’s certainly what happened last quarter.
We expect nothing different behaviorally for the third quarter reporting season vis-a-vis past trends. The questions, as always, are, what percentage of the reports will be negative pre-announcements, how many will match recent the urban myth of “light on revenues, better on bottom line” and what percentage will actually surpass all metrics pre-cast by the analysts? Yes, this is the question we and the markets ask every quarter, particularly since the market bottom in March 2009, but forgive us for asking it again, given its importance in market performance going forward. And besides, we wanted to get it in ahead of CNBC, which will repeat these lines at least 1543 times between now and November 15th, as always, forgetting that retailers’ reports come one month later.
So what to expect when you are expecting (royalties already paid to the baby book authors)? First, let’s explore what the few market watchers that have publicly spoken on the subject have been saying. Despite better than expected reported statistics and higher than expected guidance last quarter (which did nothing more than temporary for the markets) analysts are still calling for earnings misses and weaker guidance. Their reasoning? Q3 encompassed July and August, two critical months in the European debt crisis and the US ”soft spot.” So, naturally, the expectation is for weak results (perhaps weather than forecast) with soggy guidance (don’t they get that they, themselves, have already baked that fact into their numbers? Guess not). Sounds exactly like the forecast for Q2 earnings, the reality of which stubbornly didn’t comply. Is that how it will be again this time ‘round? And what will be the market reaction? Addressing the first question, we think not. As we have continually stressed, Company Management has learned from years of playing the “beat and raise” game to lower the bar to an appropriate level that can be easily hurdled without seeming suspicious. Nothing we heard last earnings season suggests that we will get anything different this time around—despite the beat and raise environment we had in Q2. No manager on a Q2 conference call was about to stick his neck out given the environment at the time so we feel confident that this fact, combined with the usual conservative game theory behavior in which managers quarterly participate, will produce yet another round of 70%+ earnings beats, given that analysts simply take Management numbers to form their own forecasts. What about guidance? Here again, we expect the same. In fact, the Company Management with whom we have spoken recently are getting more optimistic in light of expected mid-term regime change and may, in fact, be emboldened enough to say even more positive things about Q4 and beyond, especially on the hiring front—and this is despite the political affiliation of the manager (we always ask).
Market reaction? We’re tempted to flippantly (pun intended) suggest one “flip a coin.” Even though the expectations are for weak reports and guidance, the opposite may not have the expected reaction in equity prices. They didn’t, on net, during Q2 (July having been taken back in August) so what has changed that will produce a different result in October? Well, for one thing, the [very] long term data suggest that better than expected earnings reports and guidance produce stock price gains overall and alpha specifically for those companies producing it. A couple of quarters during which the markets are in a sour mood and choose to ignore that fact are statistically insignificant. This doesn’t mean October will fall in line with history, however. What we believe will give the markets a boost on better earnings in the next few months is rising investor optimism. When Q2 earnings were reported in July, investor sentiment could not have been worse and even though we got a temporary run in stock prices, the tug-of-war with macro economic data ended with macro winning and tamping down the enthusiasm and, thus, stock prices. But this quarter is different. We have investors looking optimistically toward the upcoming elections, others looking at their underperformance and realizing that further investments in 10-year Treasuries just aint gonna beat the competition, and still others looking at 2011 as the year Obama’s damage is softened by a new congress while the economy continues to heal on its own. Like us, this last group has seen productivity gains slow and capacity utilization additional reach cap-ex levels, and both recognize this means jobs and further economic growth down the road.
So, to answer our own headline question, we thing Santa comes early this year and that the turkeys will be sucking gravy come earnings season.
Monday, September 27, 2010
Ramblings of a Portfolio Manager
Is the Bear Case Really That Fragile or is Everyone Just Short?
Friday brought us a very nice rally across the US equity markets with the Dow, S&P500, NASDAQ and Russell 2000 indices all up nearly 2% or more. The rally capped off an odd week—after a strong rally on Monday, fostered by better than expected news from the Basel III bank capital accord over the weekend, where regulators gave firms more time than analysts expected to comply with stiffer capital requirements aimed at preventing future financial crises, the markets slowly began to give back the gains on the back of mixed financial data coming out of the US and Europe. Mixed data on housing starts in the US, a weaker than expected PMI out of Germany (which, of course, caused all the analysts to proclaim “the bloom is off the European rose) and the FOMC refusing to rule out further Quantitative Easing, all conspired to cause investors to start questioning the recent run up in stocks. Even Treasury yields started to head back downward again and the dollar weakened throughout the week. Then came Friday.
What happened on Friday? Thursday’s close saw the markets go from holding in positive territory all day to a strong late-day sell off. Considering that the economic data expected to be released on Friday (Durable Goods Orders and New Home Sales) was of fairly low import on the broad spectrum of impactful data, the market reaction was as odd as it was unexpected. Yet the futures opened strongly Friday morning with the one decent piece of global economic news having been released that morning being the German IFO, their version of our Business Sentiment Index, which came out stronger than expected. So what was with the rally? It may sound laughable and weak peg on which to hang one’s hat, but we truly believe that Friday’s rally was based nearly in whole on the guests who appeared on CNBC. The morning started with Jack Welch, former Chairman of GE and no fan of Obama. His strong opinions on the fate of the Obama machine and the Bush tax cuts come this election period added to the strength of the futures throughout the morning even as he declared “slow growth” in his ex-firm’s business lines. Following Jack came good old Doug Kass, the man who proclaimed the generational market bottom (and was right) on March 6th, 2009. His fairly bullish commentary on the value of stocks and own opinion on the upcoming elections added even more steam to the pre-market futures. You could almost see the shorts playing at home getting nervous as they sat at their laptops, in their boxer shorts, coffee in hand, trading on E-Trade. His final punch, however, was his call that shorting Treasuries would be the trade of the next century. Of course, outlining the reasons for this call gave him the opportunity to present some fairly bullish economic commentary, which certainly did not hurt the gathering strength.
The knock-out punch, however, was the appearance of David Tepper of Appaloosa Management, a legendary hedge fund manager who has been more right than wrong over the years and who made a killing on financial stocks last year when no one wanted them. Tepper rarely gives interviews, certainly not several hour-long appearances on financial TV, so his appearance was closely watched. Tepper didn’t disappoint. According to him, we are in a virtuous cycle (not his words) given the Fed’s stance on QE. Appaloosa typically allocates about 30% of capital to stocks and 70% to bonds and Tepper disclosed that he is still about 10% in stocks but moving more into them as he finds them cheap, particularly amid the current interest rate/Federal Reserve backdrop. To Tepper, if the economy strengthens stocks will do well. Conversely, in that scenario he thinks bonds and gold will not. On the other hand, he believes the Federal Reserve is acting as a put option for his strategy because if the economy worsens, the Fed will step in with quantitative easing, lowering long rates further and then all asset classes (except the dollar) would do well. It was his version of a win-win scenario and one could just watch the futures jump as he built his case.
All this CNBC commentary certainly added fuel to a fire that had started smoldering after the German IFO but the gasoline came at 8:30am when Durable Goods orders came in slightly better than expected, flying in the face of several back-to-back bad Philly Fed reports. Then, at 10am, New Home Sales came out mixed but overall stronger than expected and the fire was lit. Markets jumped and never came back. The funny thing about Friday’s market action was that, after the Dow hit it’s high of around +200, it sat there all day long, barely budging. No trader we questioned is quite sure why the daily stability but so much for 3pm being the most important hour of the day.
Did the favorable market opinions on TV Friday really drive the strong market reaction? And if it did, would wheeling out Nouriel Roubini and a few other bears bring it right back down? We suppose no-one will ever know the true answer but the commentary given certainly was rational, well thought out and made a helluva lot more sense to those schooled in economics (including us) than the knee-jerk “we’re the next Japan” headline grabbers that have been populating the airwaves lately. So, to answer last week’s question, are the elections already baked into market prices, we would have to say not yet. If a week’s worth of hand wringing over the margin by which Republicans will win in November managed to rock the markets back and forth only to be erased by some positive commentary from a couple of smart guys, then we think there is a lot more “kicker” left from certainty creeping into the eventual outcome of the elections and the events beyond. And to answer this week’s question, it sure seems to us like there’s a lot of non-believers out there—whether they are short or just plain underinvested, the case for being so is starting to look a little thin.
Friday brought us a very nice rally across the US equity markets with the Dow, S&P500, NASDAQ and Russell 2000 indices all up nearly 2% or more. The rally capped off an odd week—after a strong rally on Monday, fostered by better than expected news from the Basel III bank capital accord over the weekend, where regulators gave firms more time than analysts expected to comply with stiffer capital requirements aimed at preventing future financial crises, the markets slowly began to give back the gains on the back of mixed financial data coming out of the US and Europe. Mixed data on housing starts in the US, a weaker than expected PMI out of Germany (which, of course, caused all the analysts to proclaim “the bloom is off the European rose) and the FOMC refusing to rule out further Quantitative Easing, all conspired to cause investors to start questioning the recent run up in stocks. Even Treasury yields started to head back downward again and the dollar weakened throughout the week. Then came Friday.
What happened on Friday? Thursday’s close saw the markets go from holding in positive territory all day to a strong late-day sell off. Considering that the economic data expected to be released on Friday (Durable Goods Orders and New Home Sales) was of fairly low import on the broad spectrum of impactful data, the market reaction was as odd as it was unexpected. Yet the futures opened strongly Friday morning with the one decent piece of global economic news having been released that morning being the German IFO, their version of our Business Sentiment Index, which came out stronger than expected. So what was with the rally? It may sound laughable and weak peg on which to hang one’s hat, but we truly believe that Friday’s rally was based nearly in whole on the guests who appeared on CNBC. The morning started with Jack Welch, former Chairman of GE and no fan of Obama. His strong opinions on the fate of the Obama machine and the Bush tax cuts come this election period added to the strength of the futures throughout the morning even as he declared “slow growth” in his ex-firm’s business lines. Following Jack came good old Doug Kass, the man who proclaimed the generational market bottom (and was right) on March 6th, 2009. His fairly bullish commentary on the value of stocks and own opinion on the upcoming elections added even more steam to the pre-market futures. You could almost see the shorts playing at home getting nervous as they sat at their laptops, in their boxer shorts, coffee in hand, trading on E-Trade. His final punch, however, was his call that shorting Treasuries would be the trade of the next century. Of course, outlining the reasons for this call gave him the opportunity to present some fairly bullish economic commentary, which certainly did not hurt the gathering strength.
The knock-out punch, however, was the appearance of David Tepper of Appaloosa Management, a legendary hedge fund manager who has been more right than wrong over the years and who made a killing on financial stocks last year when no one wanted them. Tepper rarely gives interviews, certainly not several hour-long appearances on financial TV, so his appearance was closely watched. Tepper didn’t disappoint. According to him, we are in a virtuous cycle (not his words) given the Fed’s stance on QE. Appaloosa typically allocates about 30% of capital to stocks and 70% to bonds and Tepper disclosed that he is still about 10% in stocks but moving more into them as he finds them cheap, particularly amid the current interest rate/Federal Reserve backdrop. To Tepper, if the economy strengthens stocks will do well. Conversely, in that scenario he thinks bonds and gold will not. On the other hand, he believes the Federal Reserve is acting as a put option for his strategy because if the economy worsens, the Fed will step in with quantitative easing, lowering long rates further and then all asset classes (except the dollar) would do well. It was his version of a win-win scenario and one could just watch the futures jump as he built his case.
All this CNBC commentary certainly added fuel to a fire that had started smoldering after the German IFO but the gasoline came at 8:30am when Durable Goods orders came in slightly better than expected, flying in the face of several back-to-back bad Philly Fed reports. Then, at 10am, New Home Sales came out mixed but overall stronger than expected and the fire was lit. Markets jumped and never came back. The funny thing about Friday’s market action was that, after the Dow hit it’s high of around +200, it sat there all day long, barely budging. No trader we questioned is quite sure why the daily stability but so much for 3pm being the most important hour of the day.
Did the favorable market opinions on TV Friday really drive the strong market reaction? And if it did, would wheeling out Nouriel Roubini and a few other bears bring it right back down? We suppose no-one will ever know the true answer but the commentary given certainly was rational, well thought out and made a helluva lot more sense to those schooled in economics (including us) than the knee-jerk “we’re the next Japan” headline grabbers that have been populating the airwaves lately. So, to answer last week’s question, are the elections already baked into market prices, we would have to say not yet. If a week’s worth of hand wringing over the margin by which Republicans will win in November managed to rock the markets back and forth only to be erased by some positive commentary from a couple of smart guys, then we think there is a lot more “kicker” left from certainty creeping into the eventual outcome of the elections and the events beyond. And to answer this week’s question, it sure seems to us like there’s a lot of non-believers out there—whether they are short or just plain underinvested, the case for being so is starting to look a little thin.
Tuesday, September 14, 2010
Ramblings of a Portfolio Manager
Running Scared, Running Right
R&D tax credits for small business. $50bn to build and improve our transportation infrastructure (none of which would be spent on signs touting such!). Extension of capital gains and income tax cuts. A $30bn fund to invest in banks to lend to small business. $17bn in tax breaks to business to hire unemployed workers. Tax credits? Tax cuts? Sounds like George Bush in year 5 of his administration. Oddly enough, in the Bizzarroland that is Washington D.C. these days, these are all proposals that have come out of the Obama administration in the last month alone! Odder still are the Republicans who are breaking rank with their party to jump on the President’s bandwagon for these plans at the same time a fair number of Democrats are jumping the ship of Obama like rats. Yup, the mid-term congressional elections are coming up and with the economy wallowing in the doldrums of no-growth, the politicians up for re-election are starting to fear for their cushy jobs. Now you understand why they call this the “silly season.” Desperate times call for desperate measures and, it seems, even the starry-eyed ideologue in the White House seems to be getting the message. We had postulated that that lone intractable zealot would wait for the election outcome to head in the right (double entendre intended) direction but it seems that he actually, albeit slowly, may be taking some cues from history. Specifically we refer to the Clinton years and it sure seems from our perspective that Obama is already taking baby steps toward the middle of the political spectrum. In the 90’s this move worked for Clinton, it worked for our economy and, ultimately, it worked spectacularly for our stock market. Now, Mr. O may not care about any of these three items but he certainly has a big concern for retaining sufficient power to push through his agendas and, well, if he has to bend a little to retain that power, maybe that’s a good idea. If any of this sounds like a 180 degree turn in the administration’s thinking, it is; and for the equity markets it has been recently, and will continue to be, a good thing.
Will it last? Since the President began his (begrudgingly) pro-business stumping, the S&P 500 has risen over 60 points and the Dow is up close to 500 points. Is the market discounting a kinder, friendlier Administration post-November? Or is it looking forward to all the congressional bums being thrown out? Or is it starting to read the tea leaves that have been showing the World economy (including the US) was and is not as bad as believed in May through August? Did interest rates get just too low? Or was the market just oversold on light summer volume? Yes. The answer, in our humble opinion, is probably a combination of all these factors. Taken with the extraordinary build up of negativity in the markets since April--which we have been discussing over the last month--all these factors conspired to take what was a very over-sold US equity market and give it a lift. But, we ask again, will it last? And if so how long? Sentiment has definitely improved, the extension of the Bush tax cuts is seen as all but a given (the only debate is how far up the income ladder to extend them), Vegas is long a Republican victory in November, Obama is obviously on some pro-business narcotic (where can we buy more?) and even Warren Buffett is out saying “no way will we have a double dip.” Is all the good news already in the market? Will the markets sell off post-election day? The trader in us says “probably.” The long-term investor in us, however, says “ we still have some way to go and if the market does sell off, buy, buy, buy.” Over the last two weeks, taking advantage of historically low rates, corporate America has been drastically improving its balance sheet. Equity issues, sub 1% debt issues, 100 year bond issues, you name it, if healthy corporations could exploit the dislocations we have in interest rates and stock prices, they did it. And that bodes well for the future—for earnings and growth.
We’re buyers into mid-October when we will get a better read on the political polls. Investors will probably take whatever those polls say as an opportunity to take profits. Late October and early November may be rocky but that’s when you buy—economic data and the political landscape will be better then than they are now, earnings estimates will be higher and the market will start focusing on 2011 earnings, which are sill around $90 for the S&P500, an all time high. Remember, stock prices are a function of the multiple (Price/Earnings, for example) and that which the multiple is measuring. Right now we have a good number to measure (S&P earnings) but sentiment is keeping the multiple down. We expect late November and December will bring us a lot to be optimistic about and with both multiples and earnings estimates high, we could see a very, very nice Santa Clause rally.
R&D tax credits for small business. $50bn to build and improve our transportation infrastructure (none of which would be spent on signs touting such!). Extension of capital gains and income tax cuts. A $30bn fund to invest in banks to lend to small business. $17bn in tax breaks to business to hire unemployed workers. Tax credits? Tax cuts? Sounds like George Bush in year 5 of his administration. Oddly enough, in the Bizzarroland that is Washington D.C. these days, these are all proposals that have come out of the Obama administration in the last month alone! Odder still are the Republicans who are breaking rank with their party to jump on the President’s bandwagon for these plans at the same time a fair number of Democrats are jumping the ship of Obama like rats. Yup, the mid-term congressional elections are coming up and with the economy wallowing in the doldrums of no-growth, the politicians up for re-election are starting to fear for their cushy jobs. Now you understand why they call this the “silly season.” Desperate times call for desperate measures and, it seems, even the starry-eyed ideologue in the White House seems to be getting the message. We had postulated that that lone intractable zealot would wait for the election outcome to head in the right (double entendre intended) direction but it seems that he actually, albeit slowly, may be taking some cues from history. Specifically we refer to the Clinton years and it sure seems from our perspective that Obama is already taking baby steps toward the middle of the political spectrum. In the 90’s this move worked for Clinton, it worked for our economy and, ultimately, it worked spectacularly for our stock market. Now, Mr. O may not care about any of these three items but he certainly has a big concern for retaining sufficient power to push through his agendas and, well, if he has to bend a little to retain that power, maybe that’s a good idea. If any of this sounds like a 180 degree turn in the administration’s thinking, it is; and for the equity markets it has been recently, and will continue to be, a good thing.
Will it last? Since the President began his (begrudgingly) pro-business stumping, the S&P 500 has risen over 60 points and the Dow is up close to 500 points. Is the market discounting a kinder, friendlier Administration post-November? Or is it looking forward to all the congressional bums being thrown out? Or is it starting to read the tea leaves that have been showing the World economy (including the US) was and is not as bad as believed in May through August? Did interest rates get just too low? Or was the market just oversold on light summer volume? Yes. The answer, in our humble opinion, is probably a combination of all these factors. Taken with the extraordinary build up of negativity in the markets since April--which we have been discussing over the last month--all these factors conspired to take what was a very over-sold US equity market and give it a lift. But, we ask again, will it last? And if so how long? Sentiment has definitely improved, the extension of the Bush tax cuts is seen as all but a given (the only debate is how far up the income ladder to extend them), Vegas is long a Republican victory in November, Obama is obviously on some pro-business narcotic (where can we buy more?) and even Warren Buffett is out saying “no way will we have a double dip.” Is all the good news already in the market? Will the markets sell off post-election day? The trader in us says “probably.” The long-term investor in us, however, says “ we still have some way to go and if the market does sell off, buy, buy, buy.” Over the last two weeks, taking advantage of historically low rates, corporate America has been drastically improving its balance sheet. Equity issues, sub 1% debt issues, 100 year bond issues, you name it, if healthy corporations could exploit the dislocations we have in interest rates and stock prices, they did it. And that bodes well for the future—for earnings and growth.
We’re buyers into mid-October when we will get a better read on the political polls. Investors will probably take whatever those polls say as an opportunity to take profits. Late October and early November may be rocky but that’s when you buy—economic data and the political landscape will be better then than they are now, earnings estimates will be higher and the market will start focusing on 2011 earnings, which are sill around $90 for the S&P500, an all time high. Remember, stock prices are a function of the multiple (Price/Earnings, for example) and that which the multiple is measuring. Right now we have a good number to measure (S&P earnings) but sentiment is keeping the multiple down. We expect late November and December will bring us a lot to be optimistic about and with both multiples and earnings estimates high, we could see a very, very nice Santa Clause rally.
Tuesday, September 7, 2010
Ramblings of a Portfolio Manager
The Culture of Pessimism
The markets just closed out their worst August since 2001. After a strong July, based on good corporate earnings reports and guidance, the markets looked to be poised to continue the rally. Unfortunately, that rally lasted exactly one day into the month and then fizzled. A string of mixed economic data during the month trumped what were some fairly impressive numbers from Corporate America and investors, having been once burned in 2008, chose to shoot first and question later. The August Federal Reserve meeting, which was intended to calm the markets instead caused fear and renewed discussions of deflation and a double-dip recession. By the way, a strict definition of a double-dip assumes we have already emerged from the prior slowdown to the pre-recession GDP—we haven’t so yet just keep that in mind when the CNBC talking heads get going on their “double dip” talk.
In terms of Q2 earnings reports we had over 75% earnings beats with similar results in raised guidance. While these statistics are near an all time high and contributed to a strong July, the market’s mood turned sour in August on some of the macro economic data, particularly the Philly Fed Index, and good earnings reports, rather than being rewarded, in fact, turned into an opportunity to SELL.
The equity markets are now in a culture of pessimism. Time Magazine just ran an article questioning whether Americans should own homes. A poll of Hedge Fund managers showed the highest degree of pessimism regarding the equity markets since 2008 (47%) . The AAII index of investor bullishness is at 20%, a 5 year low. Yet another poll put investor sentiment at the lowest point since March of 2009, the “Generational Low” we hit after the financial crisis. Outflows from equity funds and into Treasury Bond funds is at the level of late 2008. Gold and US Treasuries have become cult investments with gold just off its all time high and the 10 year bond yield near its all time low. Wall Street Analysts, usually a lagging indicator, have for the first time in more than a decade, rated the percentage of stocks as Buy below 29%, down from 75% in 1997, according to Bloomberg. Paradoxically, analysts aren't telling investors to sell either, with Sell ratings remaining near a low 5%. Instead, Hold ratings have ballooned to a record 66%. All along these analysts are raising their earnings estimates for companies while dropping their target prices for their stocks. Finally, the London FT just ran an article that it has become fashionable to be negative both in the financial and popular press. Typically, all this pessimism would signal that we are nearing a low in the equity markets. But one has to have a strong stomach and a good dose of contrarianism too hold ones nose and jump into the equity markets. We have both.
We think this is an excellent time to build a portfolio in equities. Why? First of all, we were on almost every earnings conference call and spoke with management during earnings season. The tone and the guidance we heard was almost universally positive. And, nowadays, when Managements lie they do so to the downside so they can sandbag the upcoming quarter. This means the rest of the year is probably going to be better than to what they are guiding. The problem is, no one believes it. That’s why there is so much cash sitting on the sidelines and in bonds. One little hiccup in bonds and there will be a panic move into stocks, small cap stocks in particular. What will cause the hiccup? Getting those idiots out of Congress for one, better economic data (as we have seen in the last few weeks) is another. We’ve had 13 months of improving manufacturing data. At some point even the dense guys sitting in cash will get it.
We believe that the markets are discounting an economic scenario that is much worse than what exists. In addition, we have several catalysts ahead of us to further bolster equity returns. Republicans now have a 10 pt lead in the polls versus the Democrats going into the mid-term elections, the largest in 68 years. This signals political gridlock at the least, usually good for the markets, or a Republican sweep, which would ensure that the Bush Tax cuts will be extended for all income classes. Additional tax cuts may also follow a Republican regain of control. One little tidbit: the six months following a mid-term election have shown strong positive equity gains every year since 1950.
Last week we got a little taste of what a rally based on “not as bad as feared” data might look like. It was strong with many of the indicies erasing nearly all of their August losses in just three days. Will it last? That depends upon the data we continue to get but imagine the rally that would ensue if the data actually turned positive and beat consensus, if we get regime change and Obama chooses Clinton’s wise course when he lost his majority in the mid-terms and moved to the center . World equity markets have been moving up strongly for a few weeks now on strong economic data. We have not. The ‘decoupling” adherents are starting to come out of the woodwork. Their record had been very consistent—100% wrong. So if the Worlds’ economy is humming along better than expected, perhaps so is ours.
The markets just closed out their worst August since 2001. After a strong July, based on good corporate earnings reports and guidance, the markets looked to be poised to continue the rally. Unfortunately, that rally lasted exactly one day into the month and then fizzled. A string of mixed economic data during the month trumped what were some fairly impressive numbers from Corporate America and investors, having been once burned in 2008, chose to shoot first and question later. The August Federal Reserve meeting, which was intended to calm the markets instead caused fear and renewed discussions of deflation and a double-dip recession. By the way, a strict definition of a double-dip assumes we have already emerged from the prior slowdown to the pre-recession GDP—we haven’t so yet just keep that in mind when the CNBC talking heads get going on their “double dip” talk.
In terms of Q2 earnings reports we had over 75% earnings beats with similar results in raised guidance. While these statistics are near an all time high and contributed to a strong July, the market’s mood turned sour in August on some of the macro economic data, particularly the Philly Fed Index, and good earnings reports, rather than being rewarded, in fact, turned into an opportunity to SELL.
The equity markets are now in a culture of pessimism. Time Magazine just ran an article questioning whether Americans should own homes. A poll of Hedge Fund managers showed the highest degree of pessimism regarding the equity markets since 2008 (47%) . The AAII index of investor bullishness is at 20%, a 5 year low. Yet another poll put investor sentiment at the lowest point since March of 2009, the “Generational Low” we hit after the financial crisis. Outflows from equity funds and into Treasury Bond funds is at the level of late 2008. Gold and US Treasuries have become cult investments with gold just off its all time high and the 10 year bond yield near its all time low. Wall Street Analysts, usually a lagging indicator, have for the first time in more than a decade, rated the percentage of stocks as Buy below 29%, down from 75% in 1997, according to Bloomberg. Paradoxically, analysts aren't telling investors to sell either, with Sell ratings remaining near a low 5%. Instead, Hold ratings have ballooned to a record 66%. All along these analysts are raising their earnings estimates for companies while dropping their target prices for their stocks. Finally, the London FT just ran an article that it has become fashionable to be negative both in the financial and popular press. Typically, all this pessimism would signal that we are nearing a low in the equity markets. But one has to have a strong stomach and a good dose of contrarianism too hold ones nose and jump into the equity markets. We have both.
We think this is an excellent time to build a portfolio in equities. Why? First of all, we were on almost every earnings conference call and spoke with management during earnings season. The tone and the guidance we heard was almost universally positive. And, nowadays, when Managements lie they do so to the downside so they can sandbag the upcoming quarter. This means the rest of the year is probably going to be better than to what they are guiding. The problem is, no one believes it. That’s why there is so much cash sitting on the sidelines and in bonds. One little hiccup in bonds and there will be a panic move into stocks, small cap stocks in particular. What will cause the hiccup? Getting those idiots out of Congress for one, better economic data (as we have seen in the last few weeks) is another. We’ve had 13 months of improving manufacturing data. At some point even the dense guys sitting in cash will get it.
We believe that the markets are discounting an economic scenario that is much worse than what exists. In addition, we have several catalysts ahead of us to further bolster equity returns. Republicans now have a 10 pt lead in the polls versus the Democrats going into the mid-term elections, the largest in 68 years. This signals political gridlock at the least, usually good for the markets, or a Republican sweep, which would ensure that the Bush Tax cuts will be extended for all income classes. Additional tax cuts may also follow a Republican regain of control. One little tidbit: the six months following a mid-term election have shown strong positive equity gains every year since 1950.
Last week we got a little taste of what a rally based on “not as bad as feared” data might look like. It was strong with many of the indicies erasing nearly all of their August losses in just three days. Will it last? That depends upon the data we continue to get but imagine the rally that would ensue if the data actually turned positive and beat consensus, if we get regime change and Obama chooses Clinton’s wise course when he lost his majority in the mid-terms and moved to the center . World equity markets have been moving up strongly for a few weeks now on strong economic data. We have not. The ‘decoupling” adherents are starting to come out of the woodwork. Their record had been very consistent—100% wrong. So if the Worlds’ economy is humming along better than expected, perhaps so is ours.
Monday, August 23, 2010
Ramblings of a Portfolio Manager
“Dude, you’ll need a different board to catch a phat ride without a rad curve!”
It’s been nearly two weeks since the Federal Reserve last met and made the historic pronouncement of their intent to start purchasing long-dated treasuries with the runoff from their maturing MBS portfolio. Since that decision the Dow and S&P500 have fallen roughly 5% each. Harder hit, however, have been the bank stocks, which have fallen 8% as expressed by the Keefe Bruyette Bank Index, and small cap stocks with the financial-heavy Russell 2000 Index also down 8%. Thanks guys!
We opined last week on the reasons for the market’s ill take on the Fed’s decision so we won’t repeat it. Rather, we question whether the market is “getting it” in its negative view on bank stocks in particular and by extension, equities in general. The conventional wisdom of the portfolio manager is that the flattening of the treasury yield curve from the Fed’s actions will crimp bank earnings—particularly in the current environment in which most banks have been “surfing the curve” by using their near zero cost of funding (from Fed Funds, negative real rates on time deposits after fees and pitiful CD rates) to reinvest in long-dated, risk-free treasuries. We don’t disagree--with a steep yield curve, the banks were literally printing money with little risk given the Fed’s promise to hold short-term rates low for a very, very long time. Now, however, that little game seems to be over and with the other arm of the Government rushing to “help” with the Financial Reform bill, estimates are that earnings of banks and other financial institutions will fall significantly (25% or more by some estimates). Where we disagree is with the extension of the conventional wisdom to encompass the belief that this will dampen the incentive to lend, thus weakening the economy. We lost count of how many PMs appeared on TV over the last two weeks with a statement to the effect of “the market cannot recover without the banks leading the way.”
It’s been too short a time to analyze bank balance sheets to determine whether the Fed’s decision has made any substantial change in Management behavior and it could take up to a quarter or so for the information to work its way into financial statements. In the short-term, however, we can see the immediate effect on consumer behavior and at the end of the day, that’s what we all care about anyhow. Last week, mortgage refinancings were up 16%--an immediate reaction attributable to the rapid drop in long term rates. That little blip alone should put substantially more money in the pocket of the beleaguered consumer, more than whatever new fees the banks might extract thanks to Fin Reg. That’s a net positive to the economy. But what about those banks? Will a flat curve hurt them? We believe the Fed’s actions were designed to do just the opposite. By flattening the yield curve, the Fed did two things, both of which were intentional: First, it brought down mortgage rates, a shot in the arm to the ailing housing market. Secondly, it sent a message to the banks that the risk-free surfing is over and that’s a good thing. If bank Management wants to stay employed and appease shareholders, they’re going to have to find new sources of revenue. One, as we mentioned, will be to raise fees to depositors, but we feel the lower long-rate environment will more than make up for that in consumer wallets. The other is to boost net interest margin by reaching for yield—that is, by taking some risks like making loans or even buying MBSs themselves. In the latter case, the banks would be taking over the Fed’s recent job (the market didn’t like the Fed’s decision to stop MBS purchases), driving mortgage rates even lower, and in the former they would actually be spurring on economic growth. Either action would be good for the housing market, the overall economy and, ultimately, for the equity markets. We just need the Obama Administration to get out of the way and let the banks do what they do best.
It’s been nearly two weeks since the Federal Reserve last met and made the historic pronouncement of their intent to start purchasing long-dated treasuries with the runoff from their maturing MBS portfolio. Since that decision the Dow and S&P500 have fallen roughly 5% each. Harder hit, however, have been the bank stocks, which have fallen 8% as expressed by the Keefe Bruyette Bank Index, and small cap stocks with the financial-heavy Russell 2000 Index also down 8%. Thanks guys!
We opined last week on the reasons for the market’s ill take on the Fed’s decision so we won’t repeat it. Rather, we question whether the market is “getting it” in its negative view on bank stocks in particular and by extension, equities in general. The conventional wisdom of the portfolio manager is that the flattening of the treasury yield curve from the Fed’s actions will crimp bank earnings—particularly in the current environment in which most banks have been “surfing the curve” by using their near zero cost of funding (from Fed Funds, negative real rates on time deposits after fees and pitiful CD rates) to reinvest in long-dated, risk-free treasuries. We don’t disagree--with a steep yield curve, the banks were literally printing money with little risk given the Fed’s promise to hold short-term rates low for a very, very long time. Now, however, that little game seems to be over and with the other arm of the Government rushing to “help” with the Financial Reform bill, estimates are that earnings of banks and other financial institutions will fall significantly (25% or more by some estimates). Where we disagree is with the extension of the conventional wisdom to encompass the belief that this will dampen the incentive to lend, thus weakening the economy. We lost count of how many PMs appeared on TV over the last two weeks with a statement to the effect of “the market cannot recover without the banks leading the way.”
It’s been too short a time to analyze bank balance sheets to determine whether the Fed’s decision has made any substantial change in Management behavior and it could take up to a quarter or so for the information to work its way into financial statements. In the short-term, however, we can see the immediate effect on consumer behavior and at the end of the day, that’s what we all care about anyhow. Last week, mortgage refinancings were up 16%--an immediate reaction attributable to the rapid drop in long term rates. That little blip alone should put substantially more money in the pocket of the beleaguered consumer, more than whatever new fees the banks might extract thanks to Fin Reg. That’s a net positive to the economy. But what about those banks? Will a flat curve hurt them? We believe the Fed’s actions were designed to do just the opposite. By flattening the yield curve, the Fed did two things, both of which were intentional: First, it brought down mortgage rates, a shot in the arm to the ailing housing market. Secondly, it sent a message to the banks that the risk-free surfing is over and that’s a good thing. If bank Management wants to stay employed and appease shareholders, they’re going to have to find new sources of revenue. One, as we mentioned, will be to raise fees to depositors, but we feel the lower long-rate environment will more than make up for that in consumer wallets. The other is to boost net interest margin by reaching for yield—that is, by taking some risks like making loans or even buying MBSs themselves. In the latter case, the banks would be taking over the Fed’s recent job (the market didn’t like the Fed’s decision to stop MBS purchases), driving mortgage rates even lower, and in the former they would actually be spurring on economic growth. Either action would be good for the housing market, the overall economy and, ultimately, for the equity markets. We just need the Obama Administration to get out of the way and let the banks do what they do best.
Monday, August 16, 2010
Ramblings of a Portfolio Manager
Bullard vs. Buffett
The Federal Reserve held its monthly meeting last week and since then the equity markets have churned lower daily. By the end of the week all the major equity indices were down following the decision with the S&P 500 and Dow dropping 4% respectively and the Russell 2000 index of small cap stocks plunging 8%, all within three trading days. The reaction was as dramatic as it was unexpected and left all major US equity indices back in the red for the year. The Ten Year Treasury Bond yield, meanwhile, hit a 16 year low and is now below the dividend yield on the S&P 500, something that almost never happens. The pundits ascribed the market’s response to the Fed’s downgrade of expected GDP growth-- which is interesting as that was something that was widely expected--and its decision to maintain its balance sheet at current levels, essentially halting its earlier ongoing withdrawal of liquidity from the markets. The Fed also reiterated its intent to keep rates at the same level for an extended period (also expected) and to reinvest the proceeds of maturing Mortgage Backed Securities into Long Maturity Treasuries.
Forget the pundits, why did we get such a dramatic negative reaction? Typically, continued easy money policy would be seen as a positive. The simple answer is based on the Fed’s signaling. Historically, a good portion of the efficacy of the Federal Reserve has been not so much its actions as its pronouncements—that is, simple declarations of intent to proceed in one direction or another have been sufficient to achieve the desired economic results, rather than actual direct monetary intervention. Of course, the Fed tries very hard to send signals that guide the markets and economic participants to the desired behavior…and such was the case this time around. The problem is, like any type of guidance, the outcome depends upon the expectations of those that are guided. In the case of the equity markets, a recent round of strong economic data got many participants (us included) into the belief that the economy is stronger that the economic data suggest and that the Fed was of the same belief. Their downgrade of economic growth, though expected, paired with additional quantitative easing, quashed that belief for many. Had they done nothing, the markets would doubtless be much higher today.
The second issue we see with the Fed’s actions is the decision to allow short term MBS securities to roll off and to use the proceeds to buy long-dated US Treasuries. We believe the market had hoped for more open market purchases of MBS securities thereby bolstering the housing market, a weak link in our current economic recovery, with continued low mortgage rates. The current plan would simply flatten the yield curve, which for many is seen as a net negative. We disagree. First of all, mortgages are priced off the 10-30 year Treasuries so with the Fed driving down the yield on these instruments mortgage rates will fall any how. Secondly, we believe that flattening the yield curve is going to get some of the big banks off their collective conservative butts to stop “surfing” the Treasury yield curve. That is, borrowing short term at essentially zero and plowing it into risk free Treasuries at a 4% yield, free money so long as the yield curve doesn’t invert. Now, with 30 year Treasuries heading toward the 3% range, many banks will face the prospect of below historical net interest margins. How to boost them? Make loans, of course. That is what the economy really needs (other than certainty out of Washington but that’s tantamount to expecting a $1mm check from the tooth fairy) and we believe that is what the Fed had in mind with its strategy. Obviously, the market does not see it our way.
The other outcome of the Fed’s move was renewed talk of deflation. St. Louis Federal Reserve Member James Bullard has been doing the speaking circuit with his prediction that the US is heading toward a Japanese-style deflationary economy based on the Fed’s continuing zero-interest rate policy, which he believes is putting the U.S. economy at risk of falling into a Japanese-style deflationary cycle that could keep the economy weak for several years. Now, when a Fed governor speaks, the Markets listen and the current weakening expansion certainly lends credence to his beliefs. The interesting tidbit to consider is that his predictions fly in the face of the predictions of a very famous market participant, Warren Buffett. Reports have Buffett , link to report, shortening the duration of his bond holdings after warning that deficit spending could force inflation higher. Twenty-one percent of his holdings including Treasuries, municipal debt, foreign-government securities and corporate bonds were due in one year or less as of June 30, Berkshire said in a filing Aug. 6. That compares with 18 percent on March 31, and 16 percent at the end of last year’s second quarter. As Buffett was quoted as saying “The United States is spewing a potentially damaging substance into our economy -- greenback emissions. Unchecked greenback emissions will certainly cause the purchasing power of currency to melt.” Clearly, his opinion of the outcome of the Fed’s monetary policy is 180 degrees from Bullard’s.
So who to believe? We tend to follow the guys with the real world experience rather than the academics. Furthermore, based on the earnings conference calls we have sat in on we continue to hear that companies are bumping up against the limits of their productivity growth or capacity utilization. At some point, like flood water behind a dam, that has to push through in a great rush of additional hiring and plant expansion. That, we believe, will give us the growth and employment this economy needs and, ultimately inflation rather than deflation.
The Federal Reserve held its monthly meeting last week and since then the equity markets have churned lower daily. By the end of the week all the major equity indices were down following the decision with the S&P 500 and Dow dropping 4% respectively and the Russell 2000 index of small cap stocks plunging 8%, all within three trading days. The reaction was as dramatic as it was unexpected and left all major US equity indices back in the red for the year. The Ten Year Treasury Bond yield, meanwhile, hit a 16 year low and is now below the dividend yield on the S&P 500, something that almost never happens. The pundits ascribed the market’s response to the Fed’s downgrade of expected GDP growth-- which is interesting as that was something that was widely expected--and its decision to maintain its balance sheet at current levels, essentially halting its earlier ongoing withdrawal of liquidity from the markets. The Fed also reiterated its intent to keep rates at the same level for an extended period (also expected) and to reinvest the proceeds of maturing Mortgage Backed Securities into Long Maturity Treasuries.
Forget the pundits, why did we get such a dramatic negative reaction? Typically, continued easy money policy would be seen as a positive. The simple answer is based on the Fed’s signaling. Historically, a good portion of the efficacy of the Federal Reserve has been not so much its actions as its pronouncements—that is, simple declarations of intent to proceed in one direction or another have been sufficient to achieve the desired economic results, rather than actual direct monetary intervention. Of course, the Fed tries very hard to send signals that guide the markets and economic participants to the desired behavior…and such was the case this time around. The problem is, like any type of guidance, the outcome depends upon the expectations of those that are guided. In the case of the equity markets, a recent round of strong economic data got many participants (us included) into the belief that the economy is stronger that the economic data suggest and that the Fed was of the same belief. Their downgrade of economic growth, though expected, paired with additional quantitative easing, quashed that belief for many. Had they done nothing, the markets would doubtless be much higher today.
The second issue we see with the Fed’s actions is the decision to allow short term MBS securities to roll off and to use the proceeds to buy long-dated US Treasuries. We believe the market had hoped for more open market purchases of MBS securities thereby bolstering the housing market, a weak link in our current economic recovery, with continued low mortgage rates. The current plan would simply flatten the yield curve, which for many is seen as a net negative. We disagree. First of all, mortgages are priced off the 10-30 year Treasuries so with the Fed driving down the yield on these instruments mortgage rates will fall any how. Secondly, we believe that flattening the yield curve is going to get some of the big banks off their collective conservative butts to stop “surfing” the Treasury yield curve. That is, borrowing short term at essentially zero and plowing it into risk free Treasuries at a 4% yield, free money so long as the yield curve doesn’t invert. Now, with 30 year Treasuries heading toward the 3% range, many banks will face the prospect of below historical net interest margins. How to boost them? Make loans, of course. That is what the economy really needs (other than certainty out of Washington but that’s tantamount to expecting a $1mm check from the tooth fairy) and we believe that is what the Fed had in mind with its strategy. Obviously, the market does not see it our way.
The other outcome of the Fed’s move was renewed talk of deflation. St. Louis Federal Reserve Member James Bullard has been doing the speaking circuit with his prediction that the US is heading toward a Japanese-style deflationary economy based on the Fed’s continuing zero-interest rate policy, which he believes is putting the U.S. economy at risk of falling into a Japanese-style deflationary cycle that could keep the economy weak for several years. Now, when a Fed governor speaks, the Markets listen and the current weakening expansion certainly lends credence to his beliefs. The interesting tidbit to consider is that his predictions fly in the face of the predictions of a very famous market participant, Warren Buffett. Reports have Buffett , link to report, shortening the duration of his bond holdings after warning that deficit spending could force inflation higher. Twenty-one percent of his holdings including Treasuries, municipal debt, foreign-government securities and corporate bonds were due in one year or less as of June 30, Berkshire said in a filing Aug. 6. That compares with 18 percent on March 31, and 16 percent at the end of last year’s second quarter. As Buffett was quoted as saying “The United States is spewing a potentially damaging substance into our economy -- greenback emissions. Unchecked greenback emissions will certainly cause the purchasing power of currency to melt.” Clearly, his opinion of the outcome of the Fed’s monetary policy is 180 degrees from Bullard’s.
So who to believe? We tend to follow the guys with the real world experience rather than the academics. Furthermore, based on the earnings conference calls we have sat in on we continue to hear that companies are bumping up against the limits of their productivity growth or capacity utilization. At some point, like flood water behind a dam, that has to push through in a great rush of additional hiring and plant expansion. That, we believe, will give us the growth and employment this economy needs and, ultimately inflation rather than deflation.
Monday, August 2, 2010
Ramblings of a Portfolio Manager
Mr. Peabody’s Apples
The dog days of summer are upon us so we’ll spare you a lengthy treatise on some arcane aspect of finance. Instead we’d like to talk about a little children’s story, written by Madonna of all people, that we used to read to our kids. It’s based on an old Eastern European folk tale of a woman who spread a false rumor and the village wise man who challenged her to shred a feather pillow into the wind and then try to recapture all the loose down, the moral being that once out false rumors and gossip are almost impossible to recall. Sound like the internet? Sounds a lot like CNBC to us as well.
OK, confession: what we really want to do is give you a quick report card on the current earnings season to date. So far approximately 1/3rd of S&P 500--and by extension all US--companies have reported their second quarter earnings. Going into this reporting season the general consensus among the Wall Street sell side and financial media was that the second quarter reports would be good, but not great, and that management guidance would be terrible, given the turmoil in Europe and engineered slowdown in Asia. How did that consensus belief come into being? Cynically, we suspect that it originated from a Wall Street sell side analyst who was unable to update his Q3 and 2011 earnings models because the managements of companies he followed refused to spoon feed him the correct numbers. In any case, however it began, the financial media picked up the story and repeated it ad naseum, without any attempt at corroboration or even sanity test, until it became an accepted fact—it all just made so much sense (to them, anyhow).
Fast forward a month and where are we? Well, by our calculations, 78% of the companies reporting so far have beaten Wall Street earnings estimates with EPS up 42% year-over-year versus initial expectations of 27%--i.e. 15% better than forecasts. That’s almost 10% higher than the average “beat” rate since 1998. As for guidance, at least 10% of companies that have reported so far have raised guidance, 2% have lowered it with the rest maintaining their outlook for the rest of the year and into 2011. Doing the tough math, that’s 98% of reporting companies NOT seeing the future in the same way as the sell side or financial media. By the way, according to Bespoke Investment Group (whose numbers differ very slightly from ours), that’s the highest percentage spread of up vs. down guidance since 2001 and the fifth consecutive quarter where positive guidance has outnumbered lower, the longest streak since 2001. And how are the analysts and media reacting to this reality? Well, some of the feathers are back in the pillow, but the perception remains and the talking heads still manage an ominous “What will management say about the future?” at least once a day when mentioning companies due to report. In addition, beaten but not out, financial reporters, who obviously haven’t read the Mr. Peabody parable (do they even read?) have started yet another rumor: this one goes something like “While the earnings have come in better than expected and guidance has been strong, most companies have missed or not beaten on the top line.” This amounts to an admission of “Well, we may have been wrong about the first rumor but, surely, two pillows will need not be restuffed…?”
So with all the hand-wringing about the top line, what does the data say? Stuff it Baby! According to our data and others, revenues have largely followed earnings with 73% of reporting companies beating top line expectations to date, a number also well above the historical average. In fact Reuters just last week raised its year-over-year revenue growth expectations from 9% to 9.5%. While the percentage “beat” has not been as great on the top as the bottom line (5% vs 15% for EPS), the data is still in direct conflict with what we hear daily in the media. Yup, the financial media’s reaction to this fact has been to throw out the pillow entirely--to simply ignore facts and continue with the mantra of “Revenues just aren’t living up to expectations.” We suppose it makes for better headlines than “We Was Wrong!” So, in answer to our question above, no, financial reporters don’t read…or at the least they can’t read earnings reports. It’s a good thing your first grade teacher wasn’t also a financial reporter—with their ability to analyze report cards, you’d still be repeating that grade.
This morning the brains on CNBC are reporting that 1/3rd of S&P 500 companies are left to report. It appears that retailers, on a one-month lagged fiscal year, no longer count in Medialand. We wonder if any attempt will be made to return these feathers. Doubtful. As we tell our kids while they watch cartoons, “don’t believe everything you see on TV…except, for course for Spongebob.”
On next week’s installment of Misconception Becomes Mantra : How 50.6% of the stimulus package having been spent so far amounts to “almost all of it” when it hits the airwaves.
The dog days of summer are upon us so we’ll spare you a lengthy treatise on some arcane aspect of finance. Instead we’d like to talk about a little children’s story, written by Madonna of all people, that we used to read to our kids. It’s based on an old Eastern European folk tale of a woman who spread a false rumor and the village wise man who challenged her to shred a feather pillow into the wind and then try to recapture all the loose down, the moral being that once out false rumors and gossip are almost impossible to recall. Sound like the internet? Sounds a lot like CNBC to us as well.
OK, confession: what we really want to do is give you a quick report card on the current earnings season to date. So far approximately 1/3rd of S&P 500--and by extension all US--companies have reported their second quarter earnings. Going into this reporting season the general consensus among the Wall Street sell side and financial media was that the second quarter reports would be good, but not great, and that management guidance would be terrible, given the turmoil in Europe and engineered slowdown in Asia. How did that consensus belief come into being? Cynically, we suspect that it originated from a Wall Street sell side analyst who was unable to update his Q3 and 2011 earnings models because the managements of companies he followed refused to spoon feed him the correct numbers. In any case, however it began, the financial media picked up the story and repeated it ad naseum, without any attempt at corroboration or even sanity test, until it became an accepted fact—it all just made so much sense (to them, anyhow).
Fast forward a month and where are we? Well, by our calculations, 78% of the companies reporting so far have beaten Wall Street earnings estimates with EPS up 42% year-over-year versus initial expectations of 27%--i.e. 15% better than forecasts. That’s almost 10% higher than the average “beat” rate since 1998. As for guidance, at least 10% of companies that have reported so far have raised guidance, 2% have lowered it with the rest maintaining their outlook for the rest of the year and into 2011. Doing the tough math, that’s 98% of reporting companies NOT seeing the future in the same way as the sell side or financial media. By the way, according to Bespoke Investment Group (whose numbers differ very slightly from ours), that’s the highest percentage spread of up vs. down guidance since 2001 and the fifth consecutive quarter where positive guidance has outnumbered lower, the longest streak since 2001. And how are the analysts and media reacting to this reality? Well, some of the feathers are back in the pillow, but the perception remains and the talking heads still manage an ominous “What will management say about the future?” at least once a day when mentioning companies due to report. In addition, beaten but not out, financial reporters, who obviously haven’t read the Mr. Peabody parable (do they even read?) have started yet another rumor: this one goes something like “While the earnings have come in better than expected and guidance has been strong, most companies have missed or not beaten on the top line.” This amounts to an admission of “Well, we may have been wrong about the first rumor but, surely, two pillows will need not be restuffed…?”
So with all the hand-wringing about the top line, what does the data say? Stuff it Baby! According to our data and others, revenues have largely followed earnings with 73% of reporting companies beating top line expectations to date, a number also well above the historical average. In fact Reuters just last week raised its year-over-year revenue growth expectations from 9% to 9.5%. While the percentage “beat” has not been as great on the top as the bottom line (5% vs 15% for EPS), the data is still in direct conflict with what we hear daily in the media. Yup, the financial media’s reaction to this fact has been to throw out the pillow entirely--to simply ignore facts and continue with the mantra of “Revenues just aren’t living up to expectations.” We suppose it makes for better headlines than “We Was Wrong!” So, in answer to our question above, no, financial reporters don’t read…or at the least they can’t read earnings reports. It’s a good thing your first grade teacher wasn’t also a financial reporter—with their ability to analyze report cards, you’d still be repeating that grade.
This morning the brains on CNBC are reporting that 1/3rd of S&P 500 companies are left to report. It appears that retailers, on a one-month lagged fiscal year, no longer count in Medialand. We wonder if any attempt will be made to return these feathers. Doubtful. As we tell our kids while they watch cartoons, “don’t believe everything you see on TV…except, for course for Spongebob.”
On next week’s installment of Misconception Becomes Mantra : How 50.6% of the stimulus package having been spent so far amounts to “almost all of it” when it hits the airwaves.
Monday, July 26, 2010
Ramblings of a Portfolio Manager
What More Does the Market Want?
We just ended a second consecutive week during which an enormous amount of potentially positive market moving data was released. Two weeks ago we got strong earnings and forward guidance from the likes of Alcoa, CSX, GE and Intel, heard of a Goldman Sachs settlement with the SEC and learned that BP may have successfully capped its leaking well in the Gulf. Last week we saw continuing positive news: the Financial Regulation Bill was passed by the Senate and signed into law by the President, relieving much of the uncertainty surrounding the bill especially when in the final analysis the rules may take up to a decade to be implemented by which time affected firms will have adapted to or circumvented them; the results of the European bank stress tests were released, results that were much, much better than expected both in terms of the number of firms that passed and capital that needed to be raised; housing start data was in line with expectations but new permits were better than expected; weekly jobless claims came in more or less in line and the Senate approved an extension of unemployment insurance, restoring benefits to 2.5 million people; Fed Chairman Bernanke testified on Capitol Hill that the Fed does not see a double dip and maintains its 3%+ GDP growth forecast but is in no rush to hike rates and is ready to implement “QE2” should growth slow; General Electric hiked its dividend earlier than expected, a sign that they see strength in their business going forward and, finally, the string of strong corporate earnings and raised forward guidance continued with the who’s who of the Fortune 500 reporting including IBM, Microsoft, American Express, Coca Cola, Apple, UPS and Ford. The markets responded positively to this data with the Dow and S&P 500 both rallying about 2.3% over the last two weeks. This rally, however, was very choppy (markets initially dropped over 1.5% on Bernanke’s testimony) and still leaves us negative for the year with the Dow down 1% and the S&P 500 just below the flat line.
With all the positive news and dissipation of uncertainty during the last two weeks, the major market indexes still sit in the red for the year. What will it take for investors to feel comfortable enough to get back into the market and move us higher? Last week we opined on the dichotomy between the economic data and company reports. A more accurate depiction, it now appears, is reality vs. the forecasts of economists—i.e. the view from the trenches vs. that from the Ivory Tower. We reiterate our belief that the best prognosticators of the Country’s economic future are its CEOs and not politically (or otherwise) motivated egg heads, most of whom have never held a real job. Still, with all the positive chatter coming out of Corporate America, the markets languish. What more do they want?
We believe that there is one remaining piece to the puzzle, or conundrum in Alan Greenspan speak, and that is jobs. Though companies have painted a rosy outlook for their future profits, most have done so with the assumption of no new hiring. Clearly, for the markets to advance, unemployment must come down, which means these companies must incorporate additional staffing into their forecasts. Two factors are going to cause them to do this: first, their businesses must improve to the point where they cannot possibly grow Earnings Per Share fast enough to meet Wall Street expectations without brining in new workers—i.e. capacity utilization must increase to the point where productivity gains alone (i.e. using more technology or working existing employees harder) will not suffice to drive earnings higher. We believe that many companies are getting to that point right now. Just this morning Federal Express hiked its guidance, saying that they expect volumes to grow 20% this year. Given that their planes are already nearly full, they will have to add new planes, and people to fill and fly them, to meet this growth. We’ve heard similar reports from other industries, who are also beginning to ramp their capacity utilization.
The second factor that will spur hiring feeds into the first, and it involves the reduction of uncertainty regarding Government policy—both on taxes and regulation. Companies will hire when business improves but only if they are confident in estimating the marginal cost of those hires. Right now, given the uncertainty over the cost of health care reform, new taxes in 2011 and any other fiat of regulation that Congress decides to ram through between now and November, that marginal cost of hiring is almost impossible to estimate. For the future to be sufficiently clear to give CEOs the green light to hire, we are going to need a radical change in policy/behavior on Capitol Hill and the only way to achieve that is to get some good old fashioned gridlock, or better yet complete regime change, in Congress. Poll any CEO and it is highly probable that you will hear the belief that we currently have the most anti-business Government in this nation’s history occupying our seats on Capitol Hill. This isn’t necessarily our opinion—it’s a message we have consistently heard from virtually every earnings conference call we have attended—and it is a line of thinking that doesn’t encourage Managements to hire. Fortunately, the mid-term elections are only a little more than three months away and we will be getting early data from the political polls very soon. Given that markets are discounting mechanisms, this means that if the polling data shows CEOs will be getting their wish this election, then we can see continued equity gains through the fall. Let’s just hope that the “dead men walking” on Capitol Hill don’t pull the same tricks as the Corzine administration did to New Jersey just before it was ejected on its ear last fall—that is, ramming through more tax and spend policies at the 11th hour. Hopefully, those soon-to-be lame ducks will start thinking about their futures in the private sector and exercise some spending restraint for a change.
We just ended a second consecutive week during which an enormous amount of potentially positive market moving data was released. Two weeks ago we got strong earnings and forward guidance from the likes of Alcoa, CSX, GE and Intel, heard of a Goldman Sachs settlement with the SEC and learned that BP may have successfully capped its leaking well in the Gulf. Last week we saw continuing positive news: the Financial Regulation Bill was passed by the Senate and signed into law by the President, relieving much of the uncertainty surrounding the bill especially when in the final analysis the rules may take up to a decade to be implemented by which time affected firms will have adapted to or circumvented them; the results of the European bank stress tests were released, results that were much, much better than expected both in terms of the number of firms that passed and capital that needed to be raised; housing start data was in line with expectations but new permits were better than expected; weekly jobless claims came in more or less in line and the Senate approved an extension of unemployment insurance, restoring benefits to 2.5 million people; Fed Chairman Bernanke testified on Capitol Hill that the Fed does not see a double dip and maintains its 3%+ GDP growth forecast but is in no rush to hike rates and is ready to implement “QE2” should growth slow; General Electric hiked its dividend earlier than expected, a sign that they see strength in their business going forward and, finally, the string of strong corporate earnings and raised forward guidance continued with the who’s who of the Fortune 500 reporting including IBM, Microsoft, American Express, Coca Cola, Apple, UPS and Ford. The markets responded positively to this data with the Dow and S&P 500 both rallying about 2.3% over the last two weeks. This rally, however, was very choppy (markets initially dropped over 1.5% on Bernanke’s testimony) and still leaves us negative for the year with the Dow down 1% and the S&P 500 just below the flat line.
With all the positive news and dissipation of uncertainty during the last two weeks, the major market indexes still sit in the red for the year. What will it take for investors to feel comfortable enough to get back into the market and move us higher? Last week we opined on the dichotomy between the economic data and company reports. A more accurate depiction, it now appears, is reality vs. the forecasts of economists—i.e. the view from the trenches vs. that from the Ivory Tower. We reiterate our belief that the best prognosticators of the Country’s economic future are its CEOs and not politically (or otherwise) motivated egg heads, most of whom have never held a real job. Still, with all the positive chatter coming out of Corporate America, the markets languish. What more do they want?
We believe that there is one remaining piece to the puzzle, or conundrum in Alan Greenspan speak, and that is jobs. Though companies have painted a rosy outlook for their future profits, most have done so with the assumption of no new hiring. Clearly, for the markets to advance, unemployment must come down, which means these companies must incorporate additional staffing into their forecasts. Two factors are going to cause them to do this: first, their businesses must improve to the point where they cannot possibly grow Earnings Per Share fast enough to meet Wall Street expectations without brining in new workers—i.e. capacity utilization must increase to the point where productivity gains alone (i.e. using more technology or working existing employees harder) will not suffice to drive earnings higher. We believe that many companies are getting to that point right now. Just this morning Federal Express hiked its guidance, saying that they expect volumes to grow 20% this year. Given that their planes are already nearly full, they will have to add new planes, and people to fill and fly them, to meet this growth. We’ve heard similar reports from other industries, who are also beginning to ramp their capacity utilization.
The second factor that will spur hiring feeds into the first, and it involves the reduction of uncertainty regarding Government policy—both on taxes and regulation. Companies will hire when business improves but only if they are confident in estimating the marginal cost of those hires. Right now, given the uncertainty over the cost of health care reform, new taxes in 2011 and any other fiat of regulation that Congress decides to ram through between now and November, that marginal cost of hiring is almost impossible to estimate. For the future to be sufficiently clear to give CEOs the green light to hire, we are going to need a radical change in policy/behavior on Capitol Hill and the only way to achieve that is to get some good old fashioned gridlock, or better yet complete regime change, in Congress. Poll any CEO and it is highly probable that you will hear the belief that we currently have the most anti-business Government in this nation’s history occupying our seats on Capitol Hill. This isn’t necessarily our opinion—it’s a message we have consistently heard from virtually every earnings conference call we have attended—and it is a line of thinking that doesn’t encourage Managements to hire. Fortunately, the mid-term elections are only a little more than three months away and we will be getting early data from the political polls very soon. Given that markets are discounting mechanisms, this means that if the polling data shows CEOs will be getting their wish this election, then we can see continued equity gains through the fall. Let’s just hope that the “dead men walking” on Capitol Hill don’t pull the same tricks as the Corzine administration did to New Jersey just before it was ejected on its ear last fall—that is, ramming through more tax and spend policies at the 11th hour. Hopefully, those soon-to-be lame ducks will start thinking about their futures in the private sector and exercise some spending restraint for a change.
Monday, July 19, 2010
Ramblings of a Portfolio Manager
The Great Wrestling Match--Top Down vs. Bottom Up. Who Will Win? So Far it’s the Guy Fighting with the Rear View Mirror
Last week earnings season officially kicked off with reports from Alcoa, Intel and several banks. The results were dramatically different than expected…in fact they were much, much better than we or most of Wall Street had anticipated. Second quarter earnings came in as expected—stronger than expected (why does no-one ever mention the paradox in that oft-repeated phrase?)—but the guidance, which every market watcher had expected to be downbeat, was surprisingly strong. In fact both Alcoa and Intel, our two cyclical reporters, guided most of their financial metrics higher for the rest of the year. That was not what the market was expecting. The reports initially continued the market rally that had begun the week earlier: a rally which in truth had begun not in anticipation of such positive results but due to relief that Europe is not melting down and is addressing its myriad problems in a semi-rational manner (e.g. the bank stress tests). Alcoa and Intel were frosting on a cake that had already been baked. By the end of the week JPMorgan and Bank America had reported similar results with credit quality improving amid tepid loan growth and weak trading revenues. Not stellar results, but not the disaster the markets had been expecting, especially in the wake of the Financial Reform bill, which had threatened and distracted bank Management throughout most of the quarter.
The week was full of other positive news as well. BP appeared to have successfully capped its well in the Gulf (unexpectedly), Goldman Sachs settled its fight with the SEC for half of what was anticipated (unexpectedly), without having to subject itself to a show trial, and jobless claims came in lower than expected. With all this positive, unexpected news, the major indices ended the week down -1%+. Huh? Despite the prior week’s rally based, as we indicated, on bullishness on Europe, one would have expected a continued strong market. We didn’t get one and the answer lies in several economic indicators released during the week: the Empire State Manufacturers Survey and the Philly Fed Index. Both came in weaker than expected, indicating that the economy did indeed take a pause in June, and the markets decided to focus on those data points rather than the comments and outlook of company management.
With two conflicting sets of data to analyze, on which one should we rely? Let’s take a quick look at the two culprits behind last week’s decline. The Empire Manufacturer’s Survey is a very narrow survey in which New York manufacturing companies are asked to estimate the percentage changes in their sales and employment levels from year to year (2009 to 2010 in the most recent case)—both year to date and for the calendar year. In addition to being narrow, it’s a backward looking indicator, which largely reports what has happened in New York-based businesses over the last month with little commentary on expectations for the future. Last week’s survey indicated that conditions for New York manufacturers continued to improve in July, but that the pace of growth in business activity slowed substantially over the prior month (June). The new orders and shipments indexes were also positive but lower than last month’s levels and the employment indexes dipped as well, with the average work week index falling below zero for the first time this year. The future general business conditions index component was little changed, remaining close to its May and June levels but below the highs seen earlier in the year. Most of the other components of the index were also positive, but were below the peak levels reached in May. As for the forward-looking part, the median respondent reported that sales were up 7 percent for the first half of 2010 and were expected to be up 8 percent for the full calendar year, indicating continued positive growth. The release of this report on Wednesday dampened the continuation of the rally sparked by Intel and Alcoa.
The Philly Fed survey has been conducted since 1968 by the Philadelphia Federal Reserve Bank and questions manufacturers in the Third Federal Reserve District (Pennsylvania, New Jersey and Delaware) on general business conditions. It comprises a blend of manufacturing sectors and general businesses. The survey is conducted in the vein of the Purchasing Managers Index (PMI) report and has a rather high correlation with that report; it questions participants about their outlook on things such as employment, new orders, shipments, inventories and prices paid. Answers are given in the form of "better", "worse" or "same" as the previous month, and, as with the PMI, results are used to construct an index, only this index uses a median value for expansion of 0, rather than 50. The Philly Fed Report signals expansion when it is above zero and contraction when below thus a higher Philadelphia Fed Survey figure indicates a positive outlook from manufacturers, suggesting increased production. So what did Friday’s survey reveal that sent the markets down so sharply?
Results from the Survey released on Friday suggest that regional manufacturing activity continues to expand in July but has slowed over the past two months. Surveyed firms reported a decline in new orders this month compared with June. Employment showed a slight improvement this month. The survey’s broad indicators of future activity continue to suggest that the region’s manufacturing executives expect growth in business over the next six months, but optimism has waned notably in recent months. The future general activity index remained positive for the 19th consecutive month but fell to its lowest reading in 16 months. The future new orders and shipments indexes also declined notably, falling 22 and 13 points, respectively. For the 15th consecutive month, the percentage of firms expecting employment to increase over the next six months (30 percent) exceeded the percentage expecting declines (17 percent).
How do we rationalize these economic reports with what companies have said so far this quarter First, they all tell us something we already knew—that business conditions slowed in May and June. The combination of fears of a European meltdown, uncertainty surrounding the Government’s attack on financial institutions and the expiration of the Federal Housing Purchase Tax Credit, among other things, caused the consumer and some small businesses, at least, to temporarily put on the brakes. This information should have already been discounted in the markets’ 10%+ slide from its April highs. Secondly, and more interestingly, however, they show a dichotomy between what management is saying about the future in the survey responses versus what they are saying on earnings conference calls. The Empire State Survey is largely backward looking and thus says little about what its small collection of firms is thinking about the future. The Philly Fed survey, however, encompasses a larger number of firms from a broader spectrum of businesses and the outlook from this survey was somewhat more dour than what we have been hearing from company management. How do we explain that? There are several reasons, we believe. First, the Philly Fed Survey is still somewhat narrow in its geographic and business line focus versus the component companies of the S&P 500. Secondly, they are also somewhat smaller and have less foreign sales as well. Finally, the questions asked regarding the future are quite narrow versus the “free association” latitude given company management on conference calls. So what we are hearing from the survey respondents is still a narrow outlook as compared with the likes given by Alcoa, Intel or the banks. IBM and the rest of the technology companies, scheduled to report this week, will further broaden the economic commentary.
How does an investor make sense of this all? Should we believe company management, whom we all know can be promotional about their stocks, or the government reports, some of which encompass the very same companies that have given rosier outlooks on conference calls? Frankly, our money is on company management. First of all, the surveys contain a very large, rearward looking component to them. We all know that May and June were slow, as does a market down12% from its April high. Secondly, while management can say whatever they like to a government survey taker, they are making very public comments, to which they will be held, when they give earnings and sales guidance on conference call. Additionally, management teams have learned over the years that the game is to guide so as to set a low bar that will be easier to beat in the upcoming quarter. So, if anything, management guidance on conference calls to date has been conservative rather than promotional. If that’s the case, then the Q3 2010 may be even stronger than analysts have “estimated” already. Just remember, a rear view mirror may be a great way to kill the mythical medusa but given that markets are anticipatory beasts, it isn’t a good way to invest.
Last week earnings season officially kicked off with reports from Alcoa, Intel and several banks. The results were dramatically different than expected…in fact they were much, much better than we or most of Wall Street had anticipated. Second quarter earnings came in as expected—stronger than expected (why does no-one ever mention the paradox in that oft-repeated phrase?)—but the guidance, which every market watcher had expected to be downbeat, was surprisingly strong. In fact both Alcoa and Intel, our two cyclical reporters, guided most of their financial metrics higher for the rest of the year. That was not what the market was expecting. The reports initially continued the market rally that had begun the week earlier: a rally which in truth had begun not in anticipation of such positive results but due to relief that Europe is not melting down and is addressing its myriad problems in a semi-rational manner (e.g. the bank stress tests). Alcoa and Intel were frosting on a cake that had already been baked. By the end of the week JPMorgan and Bank America had reported similar results with credit quality improving amid tepid loan growth and weak trading revenues. Not stellar results, but not the disaster the markets had been expecting, especially in the wake of the Financial Reform bill, which had threatened and distracted bank Management throughout most of the quarter.
The week was full of other positive news as well. BP appeared to have successfully capped its well in the Gulf (unexpectedly), Goldman Sachs settled its fight with the SEC for half of what was anticipated (unexpectedly), without having to subject itself to a show trial, and jobless claims came in lower than expected. With all this positive, unexpected news, the major indices ended the week down -1%+. Huh? Despite the prior week’s rally based, as we indicated, on bullishness on Europe, one would have expected a continued strong market. We didn’t get one and the answer lies in several economic indicators released during the week: the Empire State Manufacturers Survey and the Philly Fed Index. Both came in weaker than expected, indicating that the economy did indeed take a pause in June, and the markets decided to focus on those data points rather than the comments and outlook of company management.
With two conflicting sets of data to analyze, on which one should we rely? Let’s take a quick look at the two culprits behind last week’s decline. The Empire Manufacturer’s Survey is a very narrow survey in which New York manufacturing companies are asked to estimate the percentage changes in their sales and employment levels from year to year (2009 to 2010 in the most recent case)—both year to date and for the calendar year. In addition to being narrow, it’s a backward looking indicator, which largely reports what has happened in New York-based businesses over the last month with little commentary on expectations for the future. Last week’s survey indicated that conditions for New York manufacturers continued to improve in July, but that the pace of growth in business activity slowed substantially over the prior month (June). The new orders and shipments indexes were also positive but lower than last month’s levels and the employment indexes dipped as well, with the average work week index falling below zero for the first time this year. The future general business conditions index component was little changed, remaining close to its May and June levels but below the highs seen earlier in the year. Most of the other components of the index were also positive, but were below the peak levels reached in May. As for the forward-looking part, the median respondent reported that sales were up 7 percent for the first half of 2010 and were expected to be up 8 percent for the full calendar year, indicating continued positive growth. The release of this report on Wednesday dampened the continuation of the rally sparked by Intel and Alcoa.
The Philly Fed survey has been conducted since 1968 by the Philadelphia Federal Reserve Bank and questions manufacturers in the Third Federal Reserve District (Pennsylvania, New Jersey and Delaware) on general business conditions. It comprises a blend of manufacturing sectors and general businesses. The survey is conducted in the vein of the Purchasing Managers Index (PMI) report and has a rather high correlation with that report; it questions participants about their outlook on things such as employment, new orders, shipments, inventories and prices paid. Answers are given in the form of "better", "worse" or "same" as the previous month, and, as with the PMI, results are used to construct an index, only this index uses a median value for expansion of 0, rather than 50. The Philly Fed Report signals expansion when it is above zero and contraction when below thus a higher Philadelphia Fed Survey figure indicates a positive outlook from manufacturers, suggesting increased production. So what did Friday’s survey reveal that sent the markets down so sharply?
Results from the Survey released on Friday suggest that regional manufacturing activity continues to expand in July but has slowed over the past two months. Surveyed firms reported a decline in new orders this month compared with June. Employment showed a slight improvement this month. The survey’s broad indicators of future activity continue to suggest that the region’s manufacturing executives expect growth in business over the next six months, but optimism has waned notably in recent months. The future general activity index remained positive for the 19th consecutive month but fell to its lowest reading in 16 months. The future new orders and shipments indexes also declined notably, falling 22 and 13 points, respectively. For the 15th consecutive month, the percentage of firms expecting employment to increase over the next six months (30 percent) exceeded the percentage expecting declines (17 percent).
How do we rationalize these economic reports with what companies have said so far this quarter First, they all tell us something we already knew—that business conditions slowed in May and June. The combination of fears of a European meltdown, uncertainty surrounding the Government’s attack on financial institutions and the expiration of the Federal Housing Purchase Tax Credit, among other things, caused the consumer and some small businesses, at least, to temporarily put on the brakes. This information should have already been discounted in the markets’ 10%+ slide from its April highs. Secondly, and more interestingly, however, they show a dichotomy between what management is saying about the future in the survey responses versus what they are saying on earnings conference calls. The Empire State Survey is largely backward looking and thus says little about what its small collection of firms is thinking about the future. The Philly Fed survey, however, encompasses a larger number of firms from a broader spectrum of businesses and the outlook from this survey was somewhat more dour than what we have been hearing from company management. How do we explain that? There are several reasons, we believe. First, the Philly Fed Survey is still somewhat narrow in its geographic and business line focus versus the component companies of the S&P 500. Secondly, they are also somewhat smaller and have less foreign sales as well. Finally, the questions asked regarding the future are quite narrow versus the “free association” latitude given company management on conference calls. So what we are hearing from the survey respondents is still a narrow outlook as compared with the likes given by Alcoa, Intel or the banks. IBM and the rest of the technology companies, scheduled to report this week, will further broaden the economic commentary.
How does an investor make sense of this all? Should we believe company management, whom we all know can be promotional about their stocks, or the government reports, some of which encompass the very same companies that have given rosier outlooks on conference calls? Frankly, our money is on company management. First of all, the surveys contain a very large, rearward looking component to them. We all know that May and June were slow, as does a market down12% from its April high. Secondly, while management can say whatever they like to a government survey taker, they are making very public comments, to which they will be held, when they give earnings and sales guidance on conference call. Additionally, management teams have learned over the years that the game is to guide so as to set a low bar that will be easier to beat in the upcoming quarter. So, if anything, management guidance on conference calls to date has been conservative rather than promotional. If that’s the case, then the Q3 2010 may be even stronger than analysts have “estimated” already. Just remember, a rear view mirror may be a great way to kill the mythical medusa but given that markets are anticipatory beasts, it isn’t a good way to invest.
Monday, July 12, 2010
Ramblings of a Portfolio Manager
It’s Summer—Good Time To Have a Nice BOD
Earnings season “officially” kicks off this evening with the arrival of Alcoa’s second quarter earnings report. The talking heads in the financial media have been analyzing this season and its relative importance to the markets for weeks now. The general consensus is that, while second quarter earnings will be strong—perhaps even stronger than expected—guidance from most management teams will be cautious to tepid at best. Europe, the ongoing anti-business attitude from the Obama Administration and the prospect of higher taxes next year are all to blame for the expected downbeat guidance. Of course, as most investors are aware, the market discounts what it expects to happen, not what has already happened and so if Management guidance is poor, then we can expect stocks to fall further. Or can we?
As we have mentioned, the financial press has been talking about this earnings season for weeks now—ever since the market started to swoon in May. As CNBC said this morning, the sentiment and expectations are “awful going into this reporting season.” Comments like that signal to us that, most likely, the markets are already discounting the poor guidance everyone is talking about. With the major indices all down over 10% from their April highs, one can make the case that quite a bit of negative news has already been baked into current stock prices. Furthermore, with all the talk on the airwaves and internet about the expectations for guidance, it is hard to believe that there is anyone remotely interested in the capital markets who isn’t already braced for bad news.
We believe that the market is setting up for a good “buy on the dips” opportunity in stocks. We’re not necessarily talking about buying on dips in the equity market overall so much as buying on the dips that may occur in the first hours or days of trading in stocks that have just reported, with Management giving weak guidance. “But wait!” you say. We just said a fair amount of negative news is already in the stocks. Might they not actually jump on weak but not disastrous guidance? Perhaps, however, at the margin there is always a hair trigger trader or two in a stock with wishful thinking regarding an earnings report. We suspect that many stocks will have initial drops upon weak Management commentary, analyst downgrades (they love to downgrade a stock after the bad news comes out—saves them work on hard forward-looking research) and earnings cuts but that most will recover within a relatively short time—perhaps in some cases the same day. We’ve seen this type of behavior before—most recently in March-April of 2009, which became a signal that all the bad news was in the market. Not that we’re suggesting another 60-70% post-earnings season rally, just that this time around, a nice BOD might just make you some money.
Earnings season “officially” kicks off this evening with the arrival of Alcoa’s second quarter earnings report. The talking heads in the financial media have been analyzing this season and its relative importance to the markets for weeks now. The general consensus is that, while second quarter earnings will be strong—perhaps even stronger than expected—guidance from most management teams will be cautious to tepid at best. Europe, the ongoing anti-business attitude from the Obama Administration and the prospect of higher taxes next year are all to blame for the expected downbeat guidance. Of course, as most investors are aware, the market discounts what it expects to happen, not what has already happened and so if Management guidance is poor, then we can expect stocks to fall further. Or can we?
As we have mentioned, the financial press has been talking about this earnings season for weeks now—ever since the market started to swoon in May. As CNBC said this morning, the sentiment and expectations are “awful going into this reporting season.” Comments like that signal to us that, most likely, the markets are already discounting the poor guidance everyone is talking about. With the major indices all down over 10% from their April highs, one can make the case that quite a bit of negative news has already been baked into current stock prices. Furthermore, with all the talk on the airwaves and internet about the expectations for guidance, it is hard to believe that there is anyone remotely interested in the capital markets who isn’t already braced for bad news.
We believe that the market is setting up for a good “buy on the dips” opportunity in stocks. We’re not necessarily talking about buying on dips in the equity market overall so much as buying on the dips that may occur in the first hours or days of trading in stocks that have just reported, with Management giving weak guidance. “But wait!” you say. We just said a fair amount of negative news is already in the stocks. Might they not actually jump on weak but not disastrous guidance? Perhaps, however, at the margin there is always a hair trigger trader or two in a stock with wishful thinking regarding an earnings report. We suspect that many stocks will have initial drops upon weak Management commentary, analyst downgrades (they love to downgrade a stock after the bad news comes out—saves them work on hard forward-looking research) and earnings cuts but that most will recover within a relatively short time—perhaps in some cases the same day. We’ve seen this type of behavior before—most recently in March-April of 2009, which became a signal that all the bad news was in the market. Not that we’re suggesting another 60-70% post-earnings season rally, just that this time around, a nice BOD might just make you some money.
Tuesday, July 6, 2010
Ramblings of a Portfolio Manager
'08 or '82?
U.S. stocks plunged last week, giving the Dow first seven-day loss since 2008. The culprits: reports of slower-than-estimated growth in jobs and factory orders and concern that China’s economy has slowed. The Dow, S&P 500 and Russell 2000 are now respectively 14%, 16% and 19% off their April 23rd highs. Another day like Friday and the Russell will be in Bear Market territory for 2010. So far this year, bond returns have exceeded stock gains by the widest margin in nine years. Not exactly how strategists had hoped the first half of the year would unfold.
At the end of last week pessimism in the equity markets was almost as high as it was when Lehman went down in 2008. In fact, the one through 10-year Treasuries ended the week yielding less than they did in mid-late September of 2008, when Lehman failed and AIG required a minimum of $85 billion in government support to stave off a collapse of the entire financial system. Memories of those times are fresh, however, and as investors wonder what will be the next shoe to drop they are dumping equities wholesale and running to the “safety” of US Treasuries, ignoring the perils of that strategy. As one portfolio manager said, “It’s like running under a tree during a thunderstorm.”
Let us say categorically that this is NOT 2008 by any stretch of the imagination although right now the equity markets are acting like it. Back then we had a true credit seizure—banks weren’t lending to other banks, one-month LIBOR rates, currently at 0.35%, exceeded 4% and even GE couldn't roll its commercial paper. We hate to use the phrase but, yes, this time is different…very different. What we have now is a softening in the labor market after a rebound off the bottom which was due in part to Fiscal stimulus. The market, always forward-looking, is ratcheting down its growth expectations—but the expectations are for growth nonetheless. In late 2008 we were staring over a precipice, wondering whether banks would open the next day, let alone how low S&P 500 earnings were going to fall. As of the end of April, S&P earnings expectations were for $100 for 2011, an all time high. Even a drastic cut of 20% would bring them back to late 2005/early 2006 levels when the equity markets were much higher than they are now. The trouble is the uncertainty factor and that is currently depressing multiples on what are declining earnings estimates—a double whammy to stock prices. Unfortunately, the uncertainty comes from our own government. The President and Congress, rather than showing concern for a U6 unemployment number hovering near 17%, are busy punishing Goldman Sachs with 2000 pages of worthless regulation. The only part of the Government that investors trust right now is Bernanke and the Federal Reserve and they are somewhat handcuffed right now given what the fools in Congress are doing. That will change, of course, and the winds are already blowing that way. But no one wants to wait until November to see how many of them get kicked out.
In our opinion, this market looks a lot more like it did in 1982 than 2008. Back in ’82, the Economy was emerging from a deep recession and growth was rapid. The Federal Reserve, seeing the 8%+ growth in GDP and having just come through a terrible period of inflation, started hiking rates too quickly. That move—too much too soon-- sent the Economy right back into recession. The markets followed in lock step and we had two back-to-back bear markets. We don’t expect that to happen this time. We have a Federal Reserve Chairman who is a student of history and not about to repeat the mistakes of the past. One mantra often heard is that the Fed is out of bullets---rubbish! The Fed can still re-instate Quantitative Easing and most likely they will, given that there is no inflation in sight. At current rates homes will sell again and there is a good chance that the home buyers tax credit will come back. Republicans will gain votes in Congress in November and the benefits from European debt-cutting measures will become clear as the year progresses. All this says to us that the markets may be setting up for a strong rally through the end of the year.
Basically we have hit the reset button after a nice run from last year and now have the same opportunities to make money as we did last spring. Investors just need to be patient, wait for the bottom and get back in—psychologically difficult we recognize, but this is where and how fortunes are made. It isn’t often that the markets hand you a second opportunity to make big money but, we believe, they are fast doing so again. No-one knows where and when the bottom will come—any day we could get news that China has taken its foot off the brakes, that the US or Europe is doing Quantitative Easing or some other positive news. Given the state of pessimism, it won’t take much. Frankly, earnings season has such low expectations, even that could initiate the turn. Just a little factoid: the S&P and Dow are now just 10% or less above where they were at the height of the AIG and Lehman crisis yet the situation is clearer, the uncertainty less and we have a strong domestic policy for growth and recovery already in place. Earnings estimates are 50% higher too. The uncertainty is much less yet the markets have barely moved. We like the way things are setting up and even though picking the precise bottom is tricky, we suggest investors begin averaging into the market now, while prices are depressed.
U.S. stocks plunged last week, giving the Dow first seven-day loss since 2008. The culprits: reports of slower-than-estimated growth in jobs and factory orders and concern that China’s economy has slowed. The Dow, S&P 500 and Russell 2000 are now respectively 14%, 16% and 19% off their April 23rd highs. Another day like Friday and the Russell will be in Bear Market territory for 2010. So far this year, bond returns have exceeded stock gains by the widest margin in nine years. Not exactly how strategists had hoped the first half of the year would unfold.
At the end of last week pessimism in the equity markets was almost as high as it was when Lehman went down in 2008. In fact, the one through 10-year Treasuries ended the week yielding less than they did in mid-late September of 2008, when Lehman failed and AIG required a minimum of $85 billion in government support to stave off a collapse of the entire financial system. Memories of those times are fresh, however, and as investors wonder what will be the next shoe to drop they are dumping equities wholesale and running to the “safety” of US Treasuries, ignoring the perils of that strategy. As one portfolio manager said, “It’s like running under a tree during a thunderstorm.”
Let us say categorically that this is NOT 2008 by any stretch of the imagination although right now the equity markets are acting like it. Back then we had a true credit seizure—banks weren’t lending to other banks, one-month LIBOR rates, currently at 0.35%, exceeded 4% and even GE couldn't roll its commercial paper. We hate to use the phrase but, yes, this time is different…very different. What we have now is a softening in the labor market after a rebound off the bottom which was due in part to Fiscal stimulus. The market, always forward-looking, is ratcheting down its growth expectations—but the expectations are for growth nonetheless. In late 2008 we were staring over a precipice, wondering whether banks would open the next day, let alone how low S&P 500 earnings were going to fall. As of the end of April, S&P earnings expectations were for $100 for 2011, an all time high. Even a drastic cut of 20% would bring them back to late 2005/early 2006 levels when the equity markets were much higher than they are now. The trouble is the uncertainty factor and that is currently depressing multiples on what are declining earnings estimates—a double whammy to stock prices. Unfortunately, the uncertainty comes from our own government. The President and Congress, rather than showing concern for a U6 unemployment number hovering near 17%, are busy punishing Goldman Sachs with 2000 pages of worthless regulation. The only part of the Government that investors trust right now is Bernanke and the Federal Reserve and they are somewhat handcuffed right now given what the fools in Congress are doing. That will change, of course, and the winds are already blowing that way. But no one wants to wait until November to see how many of them get kicked out.
In our opinion, this market looks a lot more like it did in 1982 than 2008. Back in ’82, the Economy was emerging from a deep recession and growth was rapid. The Federal Reserve, seeing the 8%+ growth in GDP and having just come through a terrible period of inflation, started hiking rates too quickly. That move—too much too soon-- sent the Economy right back into recession. The markets followed in lock step and we had two back-to-back bear markets. We don’t expect that to happen this time. We have a Federal Reserve Chairman who is a student of history and not about to repeat the mistakes of the past. One mantra often heard is that the Fed is out of bullets---rubbish! The Fed can still re-instate Quantitative Easing and most likely they will, given that there is no inflation in sight. At current rates homes will sell again and there is a good chance that the home buyers tax credit will come back. Republicans will gain votes in Congress in November and the benefits from European debt-cutting measures will become clear as the year progresses. All this says to us that the markets may be setting up for a strong rally through the end of the year.
Basically we have hit the reset button after a nice run from last year and now have the same opportunities to make money as we did last spring. Investors just need to be patient, wait for the bottom and get back in—psychologically difficult we recognize, but this is where and how fortunes are made. It isn’t often that the markets hand you a second opportunity to make big money but, we believe, they are fast doing so again. No-one knows where and when the bottom will come—any day we could get news that China has taken its foot off the brakes, that the US or Europe is doing Quantitative Easing or some other positive news. Given the state of pessimism, it won’t take much. Frankly, earnings season has such low expectations, even that could initiate the turn. Just a little factoid: the S&P and Dow are now just 10% or less above where they were at the height of the AIG and Lehman crisis yet the situation is clearer, the uncertainty less and we have a strong domestic policy for growth and recovery already in place. Earnings estimates are 50% higher too. The uncertainty is much less yet the markets have barely moved. We like the way things are setting up and even though picking the precise bottom is tricky, we suggest investors begin averaging into the market now, while prices are depressed.
Monday, June 28, 2010
Ramblings of a Portfolio Manager
To Some, Economics is Just Crap
It has come to our attention that some readers were actually disappointed by the omission of last week’s Ramblings, which was due wholly to our well deserved Father’s Day hiatus. We want you to know that the kids actually encouraged us to publish the piece despite the reverential holiday and even gave us the fodder for the pen. So, out of respect to the young ones, we will publish, at least in part, a commentary on a very sophisticated, insightful and potentially highly useful economic indicator that they stumbled upon while cruising Google Finance (yes, they are that weird).
Now, no doubt many have heard the urban legend of the hemline indicator as a stock market barometer. That old chestnut goes something to the effect that the more affluent and confident Americans feel, the higher women’s hemlines will rise as will, in tandem, the stock market. If true it is, of course, a coincident indicator that probably can be traced back to the roaring twenties when flappers prowled the speakeasies and good old Jack Kennedy Sr. ruled the booze and manipulated the markets. Interestingly, just last week the Chairman of a well-known apparel manufacturer was discussing on CNBC the “heel height” indicator as working in similar fashion (pun intended). In his humble opinion the confidence of Americans can be prognosticated by the height of women’s heels. Not to be outdone, however, our kids have advanced the “toilet paper indicator” as a check on the well-being of the consumer.
Stumbling upon an MSN Money report, they “discovered” what most of us already know; the US economy is dependent upon consumer spending and economists go to great lengths to measure the health of the consumer using the strength of shoppers as a proxy. But what most of the over-educated egg-heads tend to miss is that some of the most obvious and intuitive indicators are sales trends for simple, everyday products--for example, toilet paper. Think about it. Toilet paper is the one consumer product that everyone literally spends money on so they can flush it down the drain. So for consumers to upgrade their toilet tissue, they sure as heck must be feeling confident in their economic status; if they shift from one-ply to two-ply and, gasp, even three-ply they are, in fact, sending a signal on the state of their perceived financial well being. So what does the TPI tell us? According to RISI, a forest products industry research provider, US tissue production is up 13% so far in 2010, due solely to an increase in demand. This is after it plunged dramatically along with the economy and stock market in late 2008 and early 2009. Lending credence to the trend, Procter & Gamble recently reported mid-teens growth for their Charmin Brand (all without Mr. Whipple!) and noted that consumers are moving back toward higher-priced discretionary items after a long focus on value. We confess to not yet having done our research on fashion trends at Christian Dior or Jimmy Choo but from our limited research, to date, it appears to us that the US economy is indeed, still on a roll. [Rimshot]
OK, we actually meant to target this piece on the upcoming earnings season. There has been much handwringing in the financial press over what level of forward guidance companies will give during their second quarter conference calls, which have just begun. Most analysts are quite sure that second quarter earnings will surpass printed expectations on both the top and bottom lines but are becoming increasingly pessimistic about what Management will say about Q3 and beyond. So far we only have a handful of samples, mostly from technology companies, and they have been mixed. Oracle beat expectations, raised guidance and gave an optimistic outlook. Research in Motion barely squeaked by and was fairly dour in their forecast. We have to chalk up both cases to “company specific” issues (gee, it’s fun to sound like a real Wall Street sell side analyst!). In the case of Oracle, they are in the middle of a long-delayed corporate upgrade cycle. As for RIMM, the I-Phone and the mass of smart-phone competitors now crowding the market are stealing their share and putting pressure on prices--as an example, poor old Nokia, with no good offering, was a disaster of an earnings report last week. So what can we expect from the bulk of companies yet to report? Frankly, we have to go with the analysts this time around. It’s hard to imagine any company Management sticking their collective necks out with so much turmoil going on in the currency markets and economies around the world. There is just no upside in being a hero on a conference call—not unless you have 100% certainty that things are going to be rosy and what company ever has that?
So should you run out and sell all your US equity holdings? It’s probably a little late for that. The US equity markets, having corrected nearly 12-15% from their April peaks, are now pretty much discounting a lot of bad news on the forward-looking earnings front. The two and ten-year Treasuries yielding less today than what they did the day Lehman went bust attests to that fact. That’s not to say that individual stocks may not still take a nose dive on really bad guidance, however, in our opinion the equity markets as a collective whole have already priced in a good deal of bad news. Who really expects Alcoa, perennially the cyclical earnings report front-runner, to report stellar earnings (they have whiffed the last two quarters already) or give upbeat guidance? Does anyone think the US multi-nationals with large Euro exposure will say positive things about the next few quarters? Do you believe that the US banks, still parsing through the 1900 pages of regulatory vomit heaved upon them by a soon-to-be Lame Duck Congress, will have ebullient things to say about their earnings future? We sure don’t and neither, we believe, do other investors. Looking at the mutual fund flows, it’s pretty clear that the individual investor has fled equities yet again, so what is left in the stock market are the big institutions who are mandated to be invested. The hedge funds have sold what they want to sell and are short what they want to be short. Every institutional investor is braced for a bad earnings guidance season. There just isn’t a whole lot of optimism in the equity markets right now. We like the odds this scenario presents.
Yes, you could invest your money safely in Treasuries for the next two years and pull down a guaranteed hefty 65bps in annual return (that’s roughly 5/8th of one percent for you English majors). Or you could be a gambler and go out 10 years for a full 3.12% (pre-tax). Yeah, we know that those are guaranteed returns and a damned sight better than what you got out of equities between April 23rd and last Friday. But the lousy returns in equities over the last two months is now rear view mirror stuff. Investing is all about what to expect in and do about the future. For us, with pessimism regarding the economy and equities at an 18-month high and US bond yields at a two-year low (including the 2008 financial crisis) the odds overwhelmingly favor equities going forward. But as the kids say, just take a lot of Charmin with you as it may be a bumpy ride—better yet, 3-ply Quilted Northern as things just aren’t that bad.
It has come to our attention that some readers were actually disappointed by the omission of last week’s Ramblings, which was due wholly to our well deserved Father’s Day hiatus. We want you to know that the kids actually encouraged us to publish the piece despite the reverential holiday and even gave us the fodder for the pen. So, out of respect to the young ones, we will publish, at least in part, a commentary on a very sophisticated, insightful and potentially highly useful economic indicator that they stumbled upon while cruising Google Finance (yes, they are that weird).
Now, no doubt many have heard the urban legend of the hemline indicator as a stock market barometer. That old chestnut goes something to the effect that the more affluent and confident Americans feel, the higher women’s hemlines will rise as will, in tandem, the stock market. If true it is, of course, a coincident indicator that probably can be traced back to the roaring twenties when flappers prowled the speakeasies and good old Jack Kennedy Sr. ruled the booze and manipulated the markets. Interestingly, just last week the Chairman of a well-known apparel manufacturer was discussing on CNBC the “heel height” indicator as working in similar fashion (pun intended). In his humble opinion the confidence of Americans can be prognosticated by the height of women’s heels. Not to be outdone, however, our kids have advanced the “toilet paper indicator” as a check on the well-being of the consumer.
Stumbling upon an MSN Money report, they “discovered” what most of us already know; the US economy is dependent upon consumer spending and economists go to great lengths to measure the health of the consumer using the strength of shoppers as a proxy. But what most of the over-educated egg-heads tend to miss is that some of the most obvious and intuitive indicators are sales trends for simple, everyday products--for example, toilet paper. Think about it. Toilet paper is the one consumer product that everyone literally spends money on so they can flush it down the drain. So for consumers to upgrade their toilet tissue, they sure as heck must be feeling confident in their economic status; if they shift from one-ply to two-ply and, gasp, even three-ply they are, in fact, sending a signal on the state of their perceived financial well being. So what does the TPI tell us? According to RISI, a forest products industry research provider, US tissue production is up 13% so far in 2010, due solely to an increase in demand. This is after it plunged dramatically along with the economy and stock market in late 2008 and early 2009. Lending credence to the trend, Procter & Gamble recently reported mid-teens growth for their Charmin Brand (all without Mr. Whipple!) and noted that consumers are moving back toward higher-priced discretionary items after a long focus on value. We confess to not yet having done our research on fashion trends at Christian Dior or Jimmy Choo but from our limited research, to date, it appears to us that the US economy is indeed, still on a roll. [Rimshot]
OK, we actually meant to target this piece on the upcoming earnings season. There has been much handwringing in the financial press over what level of forward guidance companies will give during their second quarter conference calls, which have just begun. Most analysts are quite sure that second quarter earnings will surpass printed expectations on both the top and bottom lines but are becoming increasingly pessimistic about what Management will say about Q3 and beyond. So far we only have a handful of samples, mostly from technology companies, and they have been mixed. Oracle beat expectations, raised guidance and gave an optimistic outlook. Research in Motion barely squeaked by and was fairly dour in their forecast. We have to chalk up both cases to “company specific” issues (gee, it’s fun to sound like a real Wall Street sell side analyst!). In the case of Oracle, they are in the middle of a long-delayed corporate upgrade cycle. As for RIMM, the I-Phone and the mass of smart-phone competitors now crowding the market are stealing their share and putting pressure on prices--as an example, poor old Nokia, with no good offering, was a disaster of an earnings report last week. So what can we expect from the bulk of companies yet to report? Frankly, we have to go with the analysts this time around. It’s hard to imagine any company Management sticking their collective necks out with so much turmoil going on in the currency markets and economies around the world. There is just no upside in being a hero on a conference call—not unless you have 100% certainty that things are going to be rosy and what company ever has that?
So should you run out and sell all your US equity holdings? It’s probably a little late for that. The US equity markets, having corrected nearly 12-15% from their April peaks, are now pretty much discounting a lot of bad news on the forward-looking earnings front. The two and ten-year Treasuries yielding less today than what they did the day Lehman went bust attests to that fact. That’s not to say that individual stocks may not still take a nose dive on really bad guidance, however, in our opinion the equity markets as a collective whole have already priced in a good deal of bad news. Who really expects Alcoa, perennially the cyclical earnings report front-runner, to report stellar earnings (they have whiffed the last two quarters already) or give upbeat guidance? Does anyone think the US multi-nationals with large Euro exposure will say positive things about the next few quarters? Do you believe that the US banks, still parsing through the 1900 pages of regulatory vomit heaved upon them by a soon-to-be Lame Duck Congress, will have ebullient things to say about their earnings future? We sure don’t and neither, we believe, do other investors. Looking at the mutual fund flows, it’s pretty clear that the individual investor has fled equities yet again, so what is left in the stock market are the big institutions who are mandated to be invested. The hedge funds have sold what they want to sell and are short what they want to be short. Every institutional investor is braced for a bad earnings guidance season. There just isn’t a whole lot of optimism in the equity markets right now. We like the odds this scenario presents.
Yes, you could invest your money safely in Treasuries for the next two years and pull down a guaranteed hefty 65bps in annual return (that’s roughly 5/8th of one percent for you English majors). Or you could be a gambler and go out 10 years for a full 3.12% (pre-tax). Yeah, we know that those are guaranteed returns and a damned sight better than what you got out of equities between April 23rd and last Friday. But the lousy returns in equities over the last two months is now rear view mirror stuff. Investing is all about what to expect in and do about the future. For us, with pessimism regarding the economy and equities at an 18-month high and US bond yields at a two-year low (including the 2008 financial crisis) the odds overwhelmingly favor equities going forward. But as the kids say, just take a lot of Charmin with you as it may be a bumpy ride—better yet, 3-ply Quilted Northern as things just aren’t that bad.
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